Financial institutions and dishonest assistance

As the quintessential deep-pocket defendant, financial institutions are often a target of litigation when victims of fraud are casting around to seek to recoup their losses. In 2017 and 2018 there have been a series of attempts to make financial institutions liable, in three common law jurisdictions (England, Cayman and Gibraltar), for dishonestly assisting in frauds. This article considers this unusual spate of recent cases, why they are generally unsuccessful, and the key lessons from the case law for financial institutions and their advisers.

The three relevant frauds were these.

  • In the English case of Singularis v. Daiwa [2018] EWCA Civ 84, as the well-known frauds involving AHAB and the Saad group were being exposed by the credit crunch, the man at the center of those allegations, Maan Al-Sanea, defrauded Cayman company Singularis of $204 million, by instructing (as one of its directors and its sole beneficial owner), its brokerage, Daiwa, to pay Singularis’ funds to other companies in the Saad Group, in eight transfers over a period of six weeks. One of the transfers alone was for the sum of $180 million.


  • In the Cayman case of Ritter v. Butterfield, Grand Court, Williams J, May 29, 2018, a local Cayman director, David Self, had stolen $875,000 from a captive insurance company’s bank account by forging his co-director’s signature on wire transfers on eight occasions over a period of two years. Self was subsequently convicted and imprisoned for theft for five years.


  • In the Gibraltarian cases of Jyske and RBSI (Gibraltar Court of Appeal, Jan. 15 and June 12, 2018), the relevant fraud was that of the partners in a formerly well respected law firm, Marrache & Co. The three brothers who were principals in the firm had conspired to defraud clients by misusing their monies (which ought to have been segregated and held on trust in client accounts in the usual way) by treating those funds as the firm’s funds, or even the brothers’ own personal funds. Total losses as a result of the fraud were estimated to be GBP28.4 million. The firm was quickly wound up, the three brothers were made bankrupt, and were each convicted and sentenced for terms of imprisonment of between eight and 11 years.

In each case, the victims of the fraud or their representatives claimed that employees of financial institutions used by the company or partnership were sufficiently aware of a range of suspicious features of the various transactions such that they were acting dishonestly, and through them the financial institution was (vicariously) liable to account to the victims as a constructive trustee for this dishonest assistance.

Although, as is well known, that cause of action requires three elements to be satisfied: (1) breach of a fiduciary obligation or trust by the fraudster (2) assistance of the fraudster by the defendant and (3) that the assistance was dishonest in the way explained and developed in the leading cases of Tan, Twinsectra and Barlow Clowes; in reality, the battleground in all of these cases is whether anyone at the relevant financial institution had acted dishonestly.

In each of the four recent cases, the dishonesty claim ultimately failed.

  • In Singularis, two employees of Daiwa were said to be dishonest, Jonathan Metcalfe and Christopher Hudson, working in the brokerage’s credit risk and compliance departments respectively. It was said they had approved payments dishonestly by ignoring the many red flags on the account at the time, and without proper enquiry. The red flags included: a freezing order against Mr. Al-Sanea, the removal of the Saad Group’s credit ratings by the leading agencies, $80 million having been received into the account days after the freezing order with no explanation, as well as deeply suspect documentation produced like “a rabbit out of a magician’s hat.” There was a suggestion they had dishonestly ignored all this as Singluaris was Daiwa’s most profitable relationship between 2007 and 2009. Despite approving the payments without inquiry in these circumstances, Messrs Metcalfe and Hudson were not held to have been dishonest: Mr. Hudson had not had it explained to him by management what other checks he ought to be performing other than working through his standard AML/terrorist financing and sanctions list queries. As for Mr. Metcalfe, concerns held by management in respect of the Singularis account had not been passed on to him, he was relatively inexperienced, he had no motive to act dishonestly, he reasonably trusted Mr. Al-Sanea and his advisers as honest and reputable people, and he had sought to involve others in the decision to approve the payments, such action being inconsistent with any dishonest intention.


  • In Ritter, no individual employee of Butterfield was identified as having been dishonest. The implication, however, was that the bank’s various payment processing staff who had approved each of the eight forged payment transfer requests had all acted dishonestly by ignoring the alleged suspicious nature of the payments, which included what were said to be obviously forged signatures and suspicious payment descriptions. At trial, a further and wider claim was added: that the bank itself was structurally or systemically dishonest. The court dismissed the dishonesty claim in its entirety as it had been defectively pleaded by not identifying who was alleged to have been dishonest, and on what particular basis, as well as for not following the strict guidance to pleading such claims set out in the leading case of Lipkin Gorman [1989] 1 WLR 1340 (CA) (dishonesty to be pleaded as the primary not alternative claim, with distinct and separate pleading). This was held to be in breach of basic procedural fairness. Having dismissed the claim on this basis, the court went on to record that there was no evidence of dishonesty in any event, relying on the principle from Re H [1996] AC 563 (HL), that since dishonesty allegations are more serious, more cogent evidence is required in support to establish them to the civil standard on the balance of probabilities. Specifically, the court held that there was no reason to doubt the honesty of Mr. Self, who was thought to be a reputable insurance manager; that it was exceptionally rare for there to be fraud between two authorized signatories on an account; that none of the signatures were obvious forgeries once hindsight was stripped out; and that none of the payment descriptions were unusual. The court accepted evidence from Graeme Skinner, the bank’s head of Corporate Banking, reliable as to banking practice, when he said that if he had been asked to approve any of the payments at the time, he would have done so. The context of the approval of the payments was also held to be of importance when assessing whether the bank’s employees had acted improperly, “where the staff members at the Bank have to process around 20 – 30 transfers per day for corporate clients and around 8,000 wire transfers per month for clients in all divisions of the Bank…appropriate validation enquiries cannot and do not require a detailed review and cross-reference of each and every transaction.”


  • In Jyske, it was alleged that the account manager for the accounts of Marrache & Co and its associated companies was dishonest by being sufficiently on notice that the brothers were misusing client funds by paying client monies into the firm’s office account, by transferring sums from the office account to the client account, by ignoring large transfers from the client account to the office account to keep the latter within overdraft limits (putting client accounts into overdraft which were then brought into line by payments from a different client account); and by being aware of payments from client accounts to the Marrache brothers’ personal accounts and credit cards ranging from GBP5,000 to 350,000. Although Mr. Bishop was held dishonest at first instance by Justice Adrian Jack, this was overturned on appeal as the judge had imposed monitoring expectations which went beyond the expert evidence of banking practice (generally to confirm proper authority, and review transfers for AML concerns). It was also held that the bank was entitled to trust a highly rated, respectable firm of lawyers, it being “virtually unthinkable” that a partner of law firm would be misappropriating client funds. The court again referred to the “practical realities” facing Mr. Bishop in conducting his business (20 – 30 transfers a day, responsible for over 250 customers with 300 separate accounts, with the impugned transactions being only 70 over a six-year period). Finally, it was held (1) that Justice Jack at first instance had ignored the “inherent improbability of Mr. Bishop having acted dishonestly, coupled with a complete lack of motive to do so”; and (2) that bank employees are not expected to act as policemen, forensically checking across multiple accounts for suspicious patterns.


  • In RBSI, seven bank employees were alleged to be dishonest: three relationship managers, three credit managers and the head of Corporate and Financial Institutions. Justice Jack held at first instance that one relationship manager, Howard Shaw, had been dishonest as he had actually identified a need to investigate potential cross-firing of cheques and misuse of client funds, and had conducted an investigation which the judge held must have revealed the fraud, notwithstanding Mr. Shaw’s denials. The judge found that the reason Mr. Shaw did not report what he found, was in order not to “open a can of worms” for RBSI, and because he lacked the courage to act as a whistle-blower. On appeal, however, all of these findings were overturned. It was held that the basis upon which Mr. Shaw had been found to be dishonest had not been pleaded; and that the findings that Mr. Shaw had lied about deriving comfort in respect of the Marrache accounts from a previous internal investigation, as well as a meeting with the firm’s accountants, had been made on a demonstrably incorrect factual basis. The Court of Appeal also (1) held that Justice Jack had wrongly identified suspicious features on the account (bunching of payments) which neither of the banking experts had considered material (2) accepted Mr. Shaw’s evidence that he was under no obligation to continually monitor his customers’ accounts for suspicious activity (3) referred to the fact Mr. Shaw trusted the Marrache brothers as a respectable firm of solicitors and (4) held that it was an application of hindsight to say that his investigation should have been conducted more widely. Finally the Court of Appeal found Jack J’s case theory on Mr. Shaw’s motive “surprising and implausible,” as “he had nothing to gain…[but] plenty to lose: his job, his reputation and his career.”

The real principles of importance in these claims are not the precise content or definition of the legal test for dishonesty (the subject of debate in extenso in the leading appellate cases concluding with Barlow Clowes). On any analysis, the most important principles guiding the ultimate results are the legal requirements for (1) proper pleading to give fair warning of the nature of the serious case being made against the employee and the financial institution, without which there will be fundamental procedural unfairness, and (2) suitably cogent evidence to establish such serious allegations against employees in financial institutions, who are in all probability not going to have acted dishonestly.

Well-known exceptional examples of staff at financial institutions actually acting dishonestly are not hard to bring to mind (e.g. Nick Leeson at Barings, Jerome Kerviel at SocGen and Kweku Adoboli at UBS). They invariably involve a combination of a clear personal financial motive and wholesale concealment by the rogue employee, features that were notably absent in the cases discussed above.

There are, however, some key lessons for both financial institutions and their advisers from these recent cases:

First, whilst the dishonesty risk is usually negligible, there is still a risk of negligence liability for allowing payments to be made where the bank was on enquiry as to possible misappropriation (the “Quincecare duty”). Liability was established on this basis for the first time in Singularis (per Vos LJ), even though the dishonesty claim was dismissed. The negligence risk can be minimized by ensuring any concerns in respect of clients are shared amongst all relevant employees, and by training staff on the Quincecare duty and what it requires of them (as seems not to have been done at Daiwa in Singularis). One way to seek to further build on that awareness by using financial institutions’ existing systems is to make clear (e.g. on the relevant reporting form) that when an employee makes an internal SAR to the MLRO, that if there is anything in the report which suggests there might be misappropriation by an authorized party from a corporate, partnership or trust account, payments from the relevant account must be stopped while inquiries are made.

Secondly, where staff have determined to investigate possible misappropriation (as did Mr. Shaw in RBSI) it is advisable for the legal and compliance function to be informed and involved, supported by external advice where justified in the circumstances, to ensure any investigation is conducted with a proper scope and with the relevant legal obligations clearly in mind.

Thirdly, brokerages have more risk than banks as they cannot plead the “practical realities” of the level of transactions that have to be processed, in the same way a bank can (per Singularis).

Finally, whilst it is accepted in the case law that financial institutions are not “detectives” or “policemen”, and that they are not expected to continually monitor across multiple accounts for signs of fraud, as automated systems are increasingly used to perform a wider kind of monitoring than was possible hitherto (say than in the 1980’s when these principles were first established in the case law), this has the potential to increase the risk of liability, in particular if such reports are notified to relationship managers, or account managers (the employees who are most typically the target of these claims).

Sebastian Said is a partner in the Dispute Resolution Practice Group of Appleby (Cayman) Ltd). He appeared as advocate for Butterfield in its successful defense in Ritter.

Regulatory sandboxes for Fintech

Childs sandbox with toys

In November of 2018, Cayman Islands Financial Services Minister Tara Rivers announced that her ministry is planning to implement a regulatory sandbox for digital assets and other innovative financial technologies that do not neatly fall within existing regulations. According to Ms. Rivers, the aim is to “encourage, foster and incubate legitimate activities,” while ensuring, “sufficient oversight and monitoring to ensure the activities taking place are compliant, fair and transparent.”

Quoted text: A regulatory sandbox is a ‘safe space’ in which businesses can test innovative products, services, business models.The move is intended to address concerns that Cayman is falling behind other jurisdictions that have already established regulatory frameworks for digital assets. Although Cayman has hosted numerous initial coin offerings (ICOs), including the largest to date (EOS/, which raised over $4 billion), uncertainty remains as to the regulatory status of digital assets issued in the jurisdiction. A recent article on the popular software blog Hackernoon listed the top ten jurisdictions for a “worry free initial coin offering” as: (1) Switzerland, (2) Singapore, (3) Gibraltar, (4) the United States, (5) Thailand, (6) Israel, (7) France, (8) Malta, (9) Russia, and (10) Estonia.

At first glance, it may appear paradoxical that regulation should be required in order to encourage innovation. In most cases, regulation inhibits innovation (except within the narrow context of innovations enabling compliance with the regulation). However, in the case of finance, regulation is now so pervasive that innovators fear that, unless they are expressly given permission to operate, they may well be in violation of one or more regulations – now or in the near-future.

One solution to this conundrum is explicitly to pre-empt such threats by removing as many regulatory roadblocks as possible. For example, under its Digital Ledger Technology (DLT) framework, which entered into force in January 2018, Gibraltar has established a set of nine principles for the operation of DLTs. In addition, in its proposed regulation for tokens, which was scheduled to be enacted into law in late 2018, it has deemed that: “Most often, tokens do not qualify as securities under Gibraltar or EU legislation. In many cases, they represent the advance sale of products that entitle holders to access future networks or consume future services. They are akin to mobile phone companies pre-selling airtime in networks they plan to build using the proceeds of those airtime sales. As such, these tokens represent commercial products (albeit reliant on future availability and utility) and are not caught by existing securities regulation in Gibraltar.”

Switzerland has taken a slightly different approach, establishing a relatively simple and clear process for the registration of ICOs. Switzerland’s Financial Markets Authority (FINMA) rules on each application individually and applies different rules depending on whether the token is classified either as a payment, utility or asset.

Another approach, adopted first in the U.K. but now followed by several others, including Singapore, Hong Kong, Australia, Canada, India, Malaysia and Abu Dhabi, has been to create a “regulatory sandbox”. The term derives, originally, from the sandbox – a small cordoned-off area of sand in which children can experience some of the delights of the beach and experiment, building sandcastles and the like, without risk of being swept away by the tide or traipsing sand into the house. The term was then adopted by software engineers who have for years used code “sandboxes” in which they experiment with changes to a program in an environment that largely replicates but is isolated from the live code.

Fintech graphicA regulatory sandbox performs a similar function for the regulation of new technologies and business models, as the U.K.’s Financial Conduct Authority, explained when it introduced the idea in 2015: “A regulatory sandbox is a ‘safe space’ in which businesses can test innovative products, services, business models and delivery mechanisms without immediately incurring all the normal regulatory consequences of engaging in the activity in question.”

Thus, for example, in the U.K. context, “A sandbox could allow a firm to make their advice platform available to a limited number of consumers. As a safeguard, once the advice is issued, but before transactions are executed, financial advisers would review the advice. This would allow firms to learn how consumers interact with their advice platform and how their algorithm performs compared to human assessment.”

Regulatory sandboxes enable companies to develop and implement, on a small scale – i.e. with a limited number of customers – novel financial technologies that either do not neatly fall under existing regulations or could pose compliance challenges due to their unusual nature. They are also applicable to new products with an uncertain market – enabling firms to trial the products without having to go through a full regulatory review process.

Regulatory sandboxes typically require applicants to provide details of the proposed trial, demonstrate the financial wherewithal to implement the trial, specify the timeframe and scale of the trial (i.e. the number of customers, maximum size of transactions), demonstrate that the applicant has in place appropriate risk mitigation measures, and describe the planned “exit strategy” (i.e. either through expanding the program if successful or transitioning customers if not). In addition, where applicable, sandbox applicants must ensure the anonymous nature of any “test” client data used, as well as all safeguards that would be in place to maintain cybersecurity across the code base.

The UK’s FCA undertook an evaluation of its regulatory sandbox program in 2017. In its first cohort, the FCA received 146 applicants, of which it accepted 50. Of those, it found that 75 percent successfully completed testing. Moreover, it found: “Around 90 percent of firms that completed testing in the first cohort are continuing toward a wider market launch following their test. The majority of firms issued with a restricted authorization for their test have gone onto secure a full authorization following completion of their tests.”

The G20 has also been working on a proposal for a set of standards for crypto-currencies and other digital assets, with a particular focus on issues related to AML and KYC. In the communiqué from its December meeting in Buenos Aires, the G20 stated: “We will continue to monitor and, if necessary, tackle emerging risks and vulnerabilities in the financial system; and, through continued regulatory and supervisory cooperation, address fragmentation. We look forward to continued progress on achieving resilient non-bank financial intermediation.

We will step up efforts to ensure that the potential benefits of technology in the financial sector can be realized while risks are mitigated. We will regulate crypto-assets for anti-money laundering and countering the financing of terrorism in line with FATF standards, and we will consider other responses as needed.”

Given the widespread interest in new digital assets, including ICOs and other blockchain-based products, combined with the likelihood of increased scrutiny of such products from an anti-money laundering (AML) and “know your customer” (KYC) perspective, the introduction of a regulatory sandbox for these and other novel financial technologies is to be welcomed in Cayman. In so doing, it is important to create a simple application and review process.

Cayman might also follow Gibraltar’s example and specify clearly up-front which tokens will be considered securities.

The Post-War Order: What is it and why is it controversial?

What is the oft-cited “postwar order” that ostensibly is being threatened by populism? Commentators, diplomats, economists, policymakers and the public use this term to describe different concepts, frequently confusing rather than informing their listeners and readers. Such misinterpretations may trigger emotional reactions that inhibit thoughtful dialogue. This article defines these terms to facilitate meaningful discussions.

We will begin with some history. There have been three major attempts to create an international architecture in hopes of discouraging war and encouraging peaceful commerce among world’s countries. The first occurred after the Napoleonic wars, the second occurred after World War I, and the third occurred after World War II.

First order

During the Congress of Vienna from November 1814 to June 1815, Austrian Foreign Minister Klemens Wenzel Nepomuk Lothar, Prince von Metternich-Winneburg zu Beilstein, met with ambassadors from the major European powers to settle issues arising from the French Revolution and the Napoleonic wars. Instead of punishing post-Napoleonic France, Metternich included France as an equal at the Congress.

To create a sustainable peace, Metternich advocated a balance of power among the European kingdoms and empires so that no single power would be strong enough on its own to be successful in a war of aggression against the others.

Metternich created a Concert of Europe, an informal organization of the major European powers. Under this system, the United Kingdom helped to maintain the balance often by supporting weaker continental powers when conflicts arose with stronger ones. Although minor wars continued to occur, the Concert successfully diffused major crises and prevented a general European war for a century (e.g., Congress of Berlin from June 13, 1878 to July 13, 1878) until the rise of Germany upset the balance of power and led to World War I.

Second order

The second attempt to create an international architecture occurred after World War I, and this second order merits significant analysis because its failure helps to explain how and why the current system was designed. In a speech on Jan. 8, 1918, U.S. President Woodrow Wilson proposed “peace without victory” between the Allied and Associated Powers and the Central Powers based on “Fourteen Points” including the evacuation of all occupied territories, freedom of the seas, free trade, and “self determination” for the Poles and the nationalities within the Austro-Hungarian Empire.

Although British Prime Minister David Lloyd-George grudgingly supported 13 of the Fourteen Points, French Prime Minister Georges Clemenceau sarcastically dismissed them, saying «Le bon Dieu n’en avait que dix!» (“The good Lord only had ten!”).

Assuming that Wilson had spoken for all of the Allied and Associated Powers, newly installed German Chancellor Prince Maximilian of Baden decided on Oct. 5, 1918 to seek peace based on the Fourteen Points. German policymakers thought that if Kaiser Wilhelm II abdicated and a new democratic government was established, Germany would be treated as generously after World War I as France had been after the Napoleonic wars.

However, Clemenceau and Lloyd-George wanted harsh reparations and severe limits on the German armed forces. Based on these misconceptions, German Finance Minister Matthias Erzberger signed an armistice in the private railroad car of French Marshal Ferdinand Foch at 5:00 a.m. on Nov. 11, 1918 that became effective later that day at 11:00 a.m.

The Paris Peace Conference met from January 1919 to June 1919. Unlike the Congress of Vienna, Clemenceau, Lloyd-George, and Wilson excluded the German delegates from conference deliberations. Knowing that Wilson valued a League of Nations above all else, Clemenceau and Lloyd-George threatened to block its creation unless Wilson dropped his support for free trade, blamed Germany for war, and imposed reparations on Germany.
Instead of “peace without victory,” the Treaty of Versailles became “victory without peace.”

German misunderstandings before the armistice and the Treaty’s punitive provisions bred the “stabbed in the back” mythology that Adolf Hitler exploited to gain power in Germany on Jan. 30, 1933.

Moreover, Wilson’s virulent racism led him to make other blunders during the conference that would cost the United States dearly in blood and treasure as the 20th century unfolded. To protect racial segregation in the American South, Wilson blocked Japan’s proposal to ban racial discrimination in the Treaty. Japan, which had been an Ally in World War I, took Wilson’s dismissal as proof that the white Americans and Europeans would not accept the Japanese as their equal. Japanese militarists used Wilson’s action to justify Japan’s aggression against China, Japan’s Axis military alliance with Germany and Italy, and Japan’s attack on Pearl Harbor, the Philippines and European colonies in Southeast Asia.

Thinking that national self-determination was for whites only, Wilson dismissed a Vietnamese delegation led by H Chí Minh seeking Vietnam’s independence from France. After Wilson’s rejection, H turned toward communism to secure Viet Nam’s independence. From 1945 to 1973, H made France and the United States pay for Wilson’s racism.

The Treaty of Versailles established the League of Nations. However, the United States never joined. Arrogantly refusing to accept 14 minor reservations that (1) Senate Foreign Relations Committee Chairman Henry Cabot Lodge (R-MA) had proposed and (2) both France and the United Kingdom accepted, Wilson arrogantly directed Democratic Senators to vote with a handful of isolationist Republican Senators to defeat the Treaty on Nov. 19, 1919.

The absence of the United States and the League’s inability to require its member states to act against aggression left the League impotent. After Japan invaded Manchuria on Sept. 19, 1931, the League established the Lytton Commission to investigate. On Oct. 2, 1932, the commission reported that Japan was the aggressor in Manchuria. When a motion was made to condemn Japan, Japanese Ambassador Yosuke Matsuoka walked out of the League’s General Assembly. Japan formally withdrew from the League of Nations on March 27, 1933.

The League had failed and would continue to fail as the aggression of Germany, Italy and Japan became increasingly brazen during the remainder of the 1930s.

The Treaty did not address the urgent economic problems that World War I had created – the need for demobilization, the restoration of the gold standard, the resumption of international trade flows, and the reconstruction of war-ravaged areas. Reparations burdened Germany and contributed to hyperinflation. The Dawes plan, which reduced reparations payments, introduced a gold-backed Reichsmark, and encouraged American loans to Germany, stabilized the German economy in 1924.

However, Germany depended on American loans to make its reparations payments to France and the United Kingdom. In turn, France and the United Kingdom depended on German reparations to repay their wartime loans from the United States. This financial merry-go-round was inherently unstable.

Long-term sustainable global economic growth required that either (1) the United States substantially must lower its tariffs and other trade barriers and run large trade deficits so that Germany could earn enough U.S. dollars and/or gold from trade surpluses to pay its reparations and France and the United Kingdom could in turn service their wartime loans; or (2) if the United States wished to maintain high tariffs and run trade surpluses, the U.S. government must forgive its wartime loans to France and the United Kingdom so that they could afford to forgo reparations payments from Germany. The United States did neither.

Instead, President Warren Harding signed the Fordney-McCumber Tariff Act in September 1922 that raised the American ad valorem tariff rate to an average of about 38.5 percent for dutiable imports and 14 percent overall.

Unlike the prewar classical gold standard, the interwar gold standard was also an unstable hodgepodge. In 1924, British Chancellor of the Exchequer Winston Churchill announced that the United Kingdom would re-establish the pound’s convertibility into gold at its pre-war parity. In contrast, the Monetary Law of 1928, France re-established the franc’s convertibility into gold at the prevailing parity in December 1926. Resumption went smoothly in France, but not in the United Kingdom. The resulting rise in the market value of pound caused deflation, high unemployment, and a chronic balance of payments deficit in the United Kingdom.

During the 1920s, the United States had chronic balance of payments surpluses due to surpluses in its trade and primary income accounts. If the United States had revalued the dollar, and the United Kingdom had devalued the pound to reflect postwar economic reality, the worst of the Great Depression could have been avoided. Instead, the Federal Reserve lowered U.S. interest rates to address these imbalances, reduce gold inflows into the United States and outflows from the United Kingdom, and keep the United Kingdom on the gold standard at its prewar parity. The excess liquidity from the Fed’s easing while the U.S. economy was booming inflated an unsustainable bubble in the U.S. stock market, which burst in October 1929.

In the 1930s, many countries tried economic nationalism to escape from the Great Depression. Abandonment of the interwar gold standard, high tariffs to discourage imports, and competitive devaluations to boost exports became widespread. However, these “beggar-thy-neighbor” failed economically, caused the collapse of international trade, and contributed to rising international tensions.

Third order

During World War II, both Prime Minister Winston Churchill and President Franklin D. Roosevelt sought to avoid the economic and political mistakes made in the Treaty of Versailles and during the interwar years. On Jan. 1, 1942, Churchill and Roosevelt signed the “Declaration by the United Nations” that established the war and postwar aims of the Allies. Subsequently, China, the Soviet Union, and 43 other countries signed the declaration. Instead of an armistice, this group of nations sought a complete victory over the Axis. Each country pledged to use its resources to support the war and not to make a separate peace agreement with any Axis country.

Thus, the “United Nations” became the official term for the Allies during World War II. The decision in 1945 to use the same term for the successor to the League of Nations may breed confusion. The wartime United Nations conferences that shaped the current international architecture were really conferences among Allies, not conferences sponsored by the not-yet-created United Nations (UN) organization or any of its organs.

While both Churchill and Roosevelt were determined to purge the leaders of Nazism from Germany, Fascism from Italy, and militarism from Japan, neither Churchill nor Roosevelt wanted to punish ordinary Germans, Italians or Japanese. Instead of the postwar harshness of Clemenceau, Churchill and Roosevelt favored the postwar magnanimity of Metternich, in which Germany, Italy, and Japan would be reconstructed as democratic capitalist countries.

Both Churchill and Roosevelt wanted to replace the League of Nations with a stronger international organization. Both Churchill and Roosevelt envisioned that China, France, the Soviet Union, the United Kingdom and the United States would become a second Concert of Europe within this new organization and that, acting together, the “Big Five” could require other member states to act against aggression.

Moreover, both Churchill and Roosevelt thought that other new international organizations would be needed to help finance postwar reconstruction, provide stable exchange rates, and promote the progressive liberalization of international trade.

The evolution of the modern post-war order

At the risk of oversimplifying, there are four major pieces of what is now loosely though of as the postwar order.

1. The United Nations and other multilateral bodies
2. The International Monetary Fund and World Bank
3. The World Trade Organization and affiliated trade pacts
4. NATO and other military/security alliances

United Nations

On Oct. 30, 1943 during the Moscow Conference, China, the Soviet Union, the United Kingdom and the United States issued the Four Power Declaration that a new international organization should replace the League of Nations. To advance this goal, representatives of these four powers met at the Washington Conversations on International Peace and Security Organization, which is also known as the Dumbarton Oaks Conference after its meeting site, the Dumbarton Oaks house in Washington, D.C., from Aug. 21, 1944, to Oct. 7, 1944. On the final day, the delegates reached the Dumbarton Oaks Agreement, which resolved many of the issues surrounding the establishment of what would become the United Nations.

Delegates from 50 Allied countries met at the United Nations Conference on International Organization, which is also known as the San Francisco Conference after its meeting site, from April 25, 1945 to June 26, 1945. At the Yalta Conference, Churchill, Roosevelt and Soviet dictator Joseph Stalin had agreed this new international organization would have a Security Council, in which China, France, the Soviet Union, the United Kingdom and the United States would be permanent members and have a veto over Security Council actions.

The delegates at the San Francisco Conference reviewed and sometimes modified the provisions of the Dumbarton Oaks Agreement. On June 26, 1945, representatives of 50 Allied countries signed the Charter of the United Nations. Poland, which had signed the Declaration of the United Nations was absent from the San Francisco, was allowed to sign the Charter on October 15, 1945, giving the United Nations organization 51 founding member states. The Charter became effective on Oct. 24, 1945 after China, France, the Soviet Union, the United Kingdom, the United States, and a majority of the other signatory countries had ratified the Charter.

The United Nations has five main organs—the General Assembly; the Security Council; the Economic and Social Council; the International Court of Justice; and the Secretariat. The General Assembly admits new member states, approves the annual budget, elects the secretary general, the 10 non-permanent members of the Security Council, and the 53 members of the Economic and Social Council, and may adopt non-binding resolutions. The Security Council may adopt binding resolutions on member states to redress aggression and maintain peace. The Economic and Social Council may gather information and make recommendations to member states. The International Court of Justice adjudicates disputes among member states. The Secretariat is the UN’s administrative arm.

Affiliated international organizations

Another source of confusion are the 15 United Nations Specialized Agencies and two related international organizations. Article 57 and 63 of the Charter allows the Economic and Social Council to enter into agreements with independent international organizations to facilitate cooperation. There are 15 such international organizations, known as United Nations Specialized Agencies, including:

(1) the Food and Agricultural Organization (FAO);
(2) the International Civil Aviation Organization (ICAO);
(3) the International Fund for Agricultural Development (IFAD);
(4) the International Labor Organization (ILO);
(5) the International Maritime Organization (IMO);
(6) the International Monetary Fund (IMF);
(7) the International Telecommunications Union (ITU);
(8) the United Nations Educational, Scientific and Cultural Organization (UNESCO);
(9) the United Nations Industrial Development Organization (UNIDO);
(10) the Universal Postal Union (UPU);
(11) the World Bank Group;
(12) the World Health Organization (WHO);
(13) the World Intellectual Property Organization (WIPO);
(14) the World Meteorological Organization (WMO); and
(15) the World Tourism Association (UNWTO).

Two other international organizations, (1) the International Atomic Energy Agency (IAEA) and (2) the World Trade Organization (WTO), do not have agreements with the Economic and Social Council, but are described as related agencies because the IAEA and the WTO informally cooperate with the Economic and Social Council and the United National Specialized Agencies.

Although these United Nations specialized agencies are loosely part of the United Nations system, each of them is independent with its own charter, membership, governance, personnel, functions, and policy objectives. Some United Nations specialized agencies were created in the 19th century, some were created through the Treaty of Versailles along with the League of Nations, and still others were created at the end of World War II.

Some United Nations Specialized Agencies have narrow functions that support technical cooperation on a specific subject among their member-states, while others have broad economic functions. Their independence is real, and they often have policy disagreements with United Nations organs. The main channel for cooperation among United Nations organs, United Nations Specialized Agencies, and related agencies is the Chief Executive Board (CEB), which the UN Secretary General chairs. The CEB meets twice a year focusing on personnel matters.

Unaffiliated international organizations

Established in 1961, the Organization for Economic Cooperation and Development (OECD) is multilateral organization whose members are 36 mostly developed counties. The OCED supports economic research and provides comparable economic statistics on its member states and major developing countries such as China. The OCED provides a forum to coordinate economic policies among its member states. This function may be controversial. For example, OCED has advocated the reduction in tax competition.

The IMF and World Bank

While technically affiliated with the U.N., the IMF and World Bank merit separate discussion because of their significant role in the current postwar order. These organizations were created when delegates from 44 Allied countries gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, from July 1, 1944, to July 22, 1994, for the Bretton Woods Conference (formally the United Nations Monetary and Financial Conference).

The conference agreed to (1) establish a system of fixed, but adjustable exchange rates; (2) create an International Monetary Fund to promote stable exchange rates by providing short-term financial assistance to any member state that faced a balance of payments crisis to allow such member-state time to adjust its internal economic policies; and (3) create an International Bank for Reconstruction and Development (IBRD) to finance the reconstruction of necessary infrastructure destroyed during World War II. The public soon referred to the IBRD as the World Bank.

When other divisions were created, a holding company, known as the World Bank Group, was organized, and the IBRD became a division of the World Bank Group. The other divisions of the World Bank Group are the International Development Association (IDA), the International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA) and the International Centre for Settlement of Investment Disputes (ICSID). The IBRD lends at market rates and terms to newly industrializing and developing countries. The IDA lends on a non-market basis to least developed countries. In reality, IDA loans more like grants than loans. The IFC offers investment, advisory, and asset-management services to encourage private-sector development in developing countries. The MIGA offers political risk insurance and credit enhancement guarantees that protect foreign direct investments against political and non-commercial risks in developing countries.

Over the years, the missions of both the IMF and the World Bank Group have evolved. The decision of President Richard Nixon to “close the gold window” on Aug. 15, 1971 terminated the Bretton Woods system of fixed, but flexible exchange rates. By 1974, all of the major market economies let their currencies float.

Over the next decade, the IMF refocused on providing conditional assistance to newly industrializing and developing countries that face financial crises. Such IMF assistance has been controversial. IMF assistance creates a moral hazard problem, encouraging creditors in developed countries to lend more money on more generous terms to governments, banks and other financial institutions, non-financial corporations, and households in newly industrializing and developing countries. The conditions that the IMF has typically imposed involve higher taxes along with some positive structural reforms – deregulation, trade liberalization, and privatization of state-owned firms.

Once the post-World War II reconstruction had been recompleted (at least in non-communist countries) the World Bank Group, particularly the IBRD and the IDA, turned to funding large-scale infrastructure projects in developing and least developed countries from the 1960s to 1980s.

In 1990s, the World Bank Group refocused again on helping former Soviet bloc countries convert to market economies and eliminating extreme poverty in developing and least developed countries. In recent years, the World Bank has helped a number of countries to establish saving-based retirement systems, provide clean water supplies, and fund microfinance so that the poor can establish small businesses to support themselves.

The WTO and trade liberalization

The Bretton Woods conference also endorsed the progressive reduction of tariffs and the creation of an International Trade Organization (ITO) to establish the rules governing international trade. In July 1945, Congress authorized President Harry S Truman to negotiate a multilateral agreement for the reduction of tariffs. At the request of the United States, the United Nations Economic and Social Committee agreed in February 1946 to convene a United Nations Conference on Trade and Employment to draft a charter for ITO. On Oct. 30, 1947, in Geneva, Switzerland, negotiators for eight of the 23 countries (including the United States) signed a General Agreement on Tariffs and Trade (GATT).

Negotiators had intended the GATT to be an interim agreement until the ITO was established. The conference met during 1947 and reached agreement in 1948. On March 24, 1948, 56 countries signed the Havana Charter, which would have established the ITO and basic rules for international trade. Because of congressional opposition, the Senate never ratified the Havana Charter, and President Truman announced on Dec. 6, 1950, that he would no longer seek its approval. Without the United States, the ITO was stillborn. GATT signatories reluctantly agreed that they would have to transform the GATT from an interim agreement into de facto international organization. The GATT signatories held seven rounds of multilateral negotiations before the signatories agreed to create the World Trade Organization (WTO) in the Uruguay Round Agreements. The WTO came into being on Jan. 1, 1995.

Regional trade liberalization

One of the two non-discrimination principals, on which the GATT is based, is Most Favored Nation (MFN). MFN means the lowest tariff and other trade barriers on any line of trade that any WTO member agrees to with any other WTO member must be granted to all WTO members.

There are two exceptions to the MFN principal. One is the Generalized System of Preferences (GSP) that began in 1979. GSP allows developed and advanced developing countries to offer unilateral tariff and trade barrier reductions to goods from least developed countries without offering the same reductions to all WTO members. The other is the exception is for bilateral or regional free trade agreements (FTAs) and customs unions. WTO members may create FTAs and customs unions that cover “substantially all” trade in goods and services without violating their MFN commitments.

Until the mid-1980s, the only significant regional trade bloc was the European Union (EU) and its predecessors. The United States and Japan favored progressive trade liberalization through the GATT negotiating rounds and discouraged the emergence of other regional FTAs or custom unions. President Ronald Reagan changed U.S. trade policy to favor both approaches. In 1986, Reagan launched the Uruguay Round of GATT negotiations and bilateral negotiations with Canada to create the U.S.-Canada Free Trade Agreement. This U.S. policy change opened the floodgates to negotiations for FTAs worldwide.

Following the success of the Uruguay Round, progress in the WTO toward trade liberalization has stalled. Several factors account for this failure. First, the WTO operates on the basis of consensus. Any member can effective cast a veto. The veto did not matter so much when GATT negotiating rounds involved few, generally developed and newly industrializing countries. Consequently when U.S. and EU negotiators reached agreement on major issues, the United States and the European Union could count on the acquiescence of other members. The accession of China to the WTO and the growing interest of India in trade policy have created alternative power centers in the WTO with different trade agenda. Consensus has become almost impossible. Second, as tariffs have fallen, discriminatory domestic regulatory policies have become more important as trade barriers. Negotiations over discriminatory domestic regulations are inherently more difficult than negotiations over tariffs at the border.

As the trade liberalization through the WTO has stalled, regional FTAs and customs unions have multiplied. For example, the United States has 14 FTAs with 20 countries. The EU has FTAs with 34 countries. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership has 11 member-countries.

Military alliances and security cooperation

Cold War tensions prevented the United Nations from being an effective security organization. Both the Soviet Union and the United States used their vetoes in the Security Council to block any actions that threatened them or their blocs. The Security Council acted only in conflicts where none of permanent five powers thought their interests were at stake. One notable exception occurred during a Soviet boycott of the Security Council. On June 25, 1950, the Security Council adopted Resolution 82 that ordered North Korea to halt its aggression and authorized U.N. member states to use force to expel North Korean forces from South Korea. At the end of the Cold War, there was a brief period of international cooperation when it was hoped that the Security Council might function as envisioned. However, the growing rivalry among China, Russia and the United States is again enfeebling the Security Council.

Regional security organizations

Given the disappointment with the United Nations and growing threat from the Soviet bloc, the United States and its allies turned to regional security pacts, of which the most notable is the North Atlantic Treaty Organization (NATO). NATO is an intergovernmental military alliance among the United States, Canada, and 27 European countries. NATO implements the North Atlantic Treaty, which was on April 4, 1949. NATO is a system of collective security through which each of its member-states pledged to respond to an attack on any other member state by any external party. NATO provided the pattern for other bilateral or regional mutual defense treaties that the United States signed during the Cold War.


All four components of the current international architecture have critics, but they should be examined separately.

  1. The United Nations is routinely condemned for being ineffective, wasteful and anti-Western. However, the UN part of the post-war order is not under serious threat. However, the OECD is subject to considerable attacks because of its statist policy agenda.
  2. The IMF and World Bank are routinely condemned for being wasteful and anti-market. The IMF also is singled out for bailout policies that are said to encourage profligacy in developing nation and to reward sloppy lending practices by big western banks. Notwithstanding the instability than many say is caused by the IMF, this part of the postwar order is not under serious threat.
  3. The WTO and regional FTAs are under threat from a populist backlash in the United States and Europe, driven in large part by angst over financial prospects for lower-skilled workers. This part of the postwar order is under serious threat, especially because U.S. laws give the president significant unilateral powers over trade policy.
  4. NATO and other security arrangements are being questioned for both cost and changing geopolitical factors (e.g., the rise of China, Islamic terrorism). While unlikely at this point, dramatic policy changes from the United States could substantially alter the structure and/or operation of these military alliances.


The so-called postwar order is not a monolithic entity. There are separate components that serve separate purposes. All were started with good intentions. Some have been very successful. Consider, for instance, the sweeping reduction in trade barriers and the concomitant rise in cross-border commerce. While populists grouse, there is deep support in most nations to protect and preserve world trade.

But other parts of the post-war order do not have very strong track records. Bureaucracies such as the IMF and OECD arguably deserve some hostile attention because of their support for anti-market policies.

Policymakers who want to preserve the best parts of the post-war order may want to consider whether it is time to jettison or reform the harmful parts.

The author of this article, who goes by the name “Hamilton” is a senior U.S. economist who frequently writes under a nom de plume.

R.I.P.? Dying to close an offshore account

The FBAR, the Financial Crimes Enforcement Network (FinCEN) Form 114, was developed by the U.S. Department of the Treasury to collect and analyze information about financial transactions in order to combat domestic and international money laundering and terrorist financing.

The FBAR, the Financial Crimes Enforcement Network (FinCEN) Form 114, was developed by the U.S. Department of the Treasury to collect and analyze information about financial transactions in order to combat domestic and international money laundering and terrorist financing.

As Americans age, those decreasing few who still maintain a foreign bank account confront a sobering conundrum. What do they do about it? Perhaps their plan years ago was to protect assets, to ensure privacy or even to avoid confiscatory taxes. But while they were not looking, the offshore account they funded in the 1990’s grew to a sizeable pot of money. The irony is that their departure may have the opposite effect from what they intended long ago – making the account very visible, vulnerable to creditors like the U.S. government and depriving their loved ones of the benefit of their savings.

Take the case of the fictitious Earl Higginbotham who faces this all-too non-fictitious problem. Finally acknowledging the possibility of his own mortality, Earl visits his estate planning lawyer, the venible Mr. Stoneface. A befuddled Mr. Stoneface then poses two daunting questions to Earl. “You have what?”; followed closely by, “When were you planning on telling me?”

Holding an offshore account in and of itself is no crime. It is not even morally questionable. It may even be salutatory. But many in Mr. Higginbotham’s shoes are shocked to learn the U.S. disclosure requirements portend severe penalties if they disclose the account, and even severer one if they do not. Mr. Higginbotham’s questions for Mr. Stoneface abound. So, I did not disclose the account. How serious can an omission of disclosure really be? But don’t these penalties die with me? How do I transfer these funds without having them confiscated by the U.S. government? How will my personal representative deal with this mess if I do not? The answer it turns out is as unclear as the afterlife. But one thing is certain, if Mr. Higginbotham takes no action, his death will visit upon his heirs the very same dilemma he now seeks to avoid.

How bad can this be?

Let us start by looking at the first question Ms. Higginbotham poses. To fully understand the abyss into which Mr. Higginbotham stares, we need to look once again at just how seriously fraught with peril the tortuous road for nondisclosure has become. His problems really do not end with, or perhaps even concern tax lability, as many foreign accounts generate little income if they generate any income at all. Rather, his problems center around the reporting requirements. And prominent among these is not an IRS form itself at all. The form that carries the most ominous penalties is appropriately referred to as the “FBAR.”

The FBAR, the Financial Crimes Enforcement Network (FinCEN) Form 114, was developed by the U.S. Department of the Treasury to collect and analyze information about financial transactions in order to combat domestic and international money laundering and terrorist financing. The filing requirements have a long history – they stem from the 1970, “Currency and Foreign Transactions Reporting Act,” commonly referred to as the Bank Secrecy Act (Title 31 U.S.C. §§ 5311-5314, 5316-5332) – but they have been given renewed vigor following the events of Sept. 11, 2001.

Unless Mr. Higginbotham was a poor saver, he is subject to these requirements. The FBAR filing threshold is already low. With the ravages of inflation, it will become inexorably negligible. Today, taxpayers with a foreign bank account exceeding $10,000 are required to file the FBAR form; and this threshold is determined by looking at accounts in the aggregate for any point during the year. To grasp of how inflation erodes the filing requirement, a future Mr. Higginbotham, in the next two decades, will be required to report less than $4,000 in present value.

Mr. Higginbotham of course did not file the form (and it must be filed electronically). And as a result, the penalties he confronts are some of the highest in the Internal Revenue Code (the Code). A non-willful violation generates a penalty of up to $10,000 per year for the years that remain open under the statute of limitations (31 USC 5321(a)(5)). If his failure to report is considered willful, then the penalty is the greater of 50 percent of what is not reported or $100,000. For example, if his account balance was $6,000,000, he could face a maximum penalty of $3,000,000 if the transgression was willful. However, for each year the FBAR is not filed, the penalty is imposable again. Therefore, it is quite possible for the maximum FBAR penalty to be multiples of the balance in offshore accounts, whether or not the failure to report was willful. And as we will see below, the IRS has relished the opportunity to impose penalties that not only wipe out the account but require the taxpayer to pony up more funds.

Worse, whether or not the failure to file was willful is a low bar. Technically, this depends on whether or not Mr Higginbotham voluntarily committed an intentional violation of a known legal duty (Internal Revenue Manual section Although the government has the burden to prove this, the only thing they would need to show is that Mr. Higginbotham knew of the reporting requirements (those same requirements, of which Mr. Stoneface advised him to prevent a malpractice suit by Mr. Higginbotham, Jr.) but purposefully chose not to report. What weight of proof is required is unsettled. The IRS itself actually believes the burden of proof is by clear and convincing evidence (IRS CCA 200603026), but some courts have sua sponte and inexplicably imposed a lesser, preponderance-of-the-evidence standard.
“But I didn’t know about the law,” Mr. Higginbotham whines. “So, what,” responds Mr. Stoneface, “you do now.”

“And whether you can claim ignorance of the law is dicey in any event.”

Mr. Stoneface is right. Two cases, U.S. v. Williams, 110 AFTR 2d 2012-5298, 489 Fed. Appx. 655 (4th Cir. 2012) and U.S. vs. McBride, 908 F. Supp. 2d 1186 (D. Utah 2012), show that courts have found taxpayers who simply failed to discuss their financial strategy with their respective accountants to be willful. They were willful because they put themselves in a position of being willfully ignorant. And if Messrs. Williams’ and McBride’s omissions were viewed as purposeful ignorance by the court, then doing nothing after actually discussing the issue with his counsel would seem to qualify Mr. Higginbotham for the willful side of the penalty. In short, subjective knowledge is not required for a taxpayer to have willfully failed to timely with the FBAR requirements. Of course, the penalties attach irrespective of any tax owed; so theoretically, even if Mr. Higginbotham suffered an economic loss in his foreign account he would still have to account for the penalties.

“Alright, damnit,” Mr. Higginbotham blurts, “please make it stop.” To make matters worse, Mr. Stoneface advised him, in certain circumstances a willful violation will also be criminal in nature. If so, the criminal penalties include up to a $250,000 fine or five years in jail. And because the willful failure to file an FBAR is a felony, it can result in collateral consequences such as the loss of the rights to vote and bear arms. It can hamstring the defendant by taking away his professional licenses. And for a permanent resident, it can mean deportation after jail time has been served.

“You’ve told me far too much,” sighs an exasperated Mr. Higginbotham, as he slumps further into Mr. Stoneface’s leather chair. “Well, actually not quite enough,” Mr. Stoneface responds.

The FBRA is not the only reporting requirement. To be sure, to be sure, several year ago Congress enacted the The Foreign Account Tax Compliance Act (FATCA), which creates separate requirements which “do not replace or otherwise affect a taxpayer’s obligation to file FBAR.”1

Unlike FBAR form filed with FinCEN, the Form 8938 (the Statement of Specified Foreign Financial Assets), which provide details about the foreign accounts, is filed with the Internal Revenue Service. Form 8938’s filing requirement is triggered in part by the taxpayer checking off the item in Schedule B (Line 7a of Part III) of their Form 1040, regarding the foreign bank account. The requirement exists whether account balance of the foreign financial assets totals more than $50,000 on the last day of the year or more than $75,000 at any time during the year for single filing statue ($100,000 and $150,000, respectively for married taxpayer filing jointly).

The filing of the IRS form is critical. The statute of limitations on a fraudulent return never runs, meaning that the failure to identify the account can create a permanent tax problem.

The taxpayer who signs a return without disclosing the existence of a foreign account may be considered to have committed tax fraud and perjury, both felonies. Indeed, there are at least thirteen possible additional forms that a taxpayer would need to file. These include the Forms 926 (Transfers to Foreign Corporations), Form 1042 (Payment to Foreign taxpayers) and a penalty of other potential filings; including, Forms 3520, 5471, 5472, 8233, 8621, 8833, 8840, 8858, 8865, 8938 and W-8BEN.

Does death do the penalties part?

After Mr. Higginbotham met Mr. Stoneface’s demand for an increased retainer, Messrs. Higginbotham and Stoneface resumed their discussion. Mr. Higginbotham asked a question often contemplated by kindred spirits. “Suppose I just die. Isn’t death enough punishment? Won’t the penalties just go away?” But Mr. Stoneface answers that question with a qualified “no,” explaining that Mr. Higginbotham is also potentially gifting a serious problem to his offspring. “Unfortunately, the sins of the father may leave your childrens’ (or Mrs. Higginbotham’s) teeth ajar.”

“What is the reach of the responsibility?” “Well, suffice it to say that it may very well live beyond you, Mr. Higginbotham. To begin with, Mr. Higginbotham, if you granted your wife or child signature authority over the account, or through a power of attorney there exists signature authority, the reporting requirements can be imposed upon them as your nominee or alter ego, even if they have no financial interest in the account.”

“Second,” Mr. Stoneface explained “a penalty (and any tax liability) can effectively attach to the personal representative directly.” He is right again. Pursuant to Title 31 U.S.C section 3713 any personal representative who pays any part of a debt of the estate before paying a claim of the government is lability to the tend of the payment for unpaid claims of the government. As a result, if Mr. Higginbotham’s son, acting as the personal representative had notice of the government claim or of “facts that would lead a reasonably prudent person to inquire as to the existence of the debt owed …” he will be charged with the responsibility.

See, United States v. Coppola, 85 F.3d 1015 (2d Cir. 1996).

“But perhaps more importantly, there is a sort of after-life or at least limbo for the penalties that could have been applied to the decedent,” Stoneface explained. In fact, if Mr. Higginbotham is caught red handed, the FBAR penalties may survive him regardless of whether or not the personal representative knew of the account.

A case on point here is U.S. v. Est. of Schoenfeld, 3:16-CV-1248-J-34PDB, 2018 WL 4599743 (M.D. Fla. Sept. 25, 2018), which has traveled though the international tax bar like wildfire. Under the facts in Schoenfeld, Steven Schoenfeld a U.S citizen, opened a Swiss bank account with UBS AG, which generated income from interest and devices. A decade later, UBS warned Mr. Schoenfeld and others that their account information may be provided to the IRS. In 2010, UBS closed Schoenfeld’s account and wired the funds to a U.S. brokerage account, which sole beneficiary was Schoenfeld’s son, Robert. Seeing this, the IRS assessed Schoenfeld a penalty of $614,300 – half the value of the account.

In 2015 Schoenfeld passed away, after having appointed Robert to act as his personal representative. The U.S. then proceeded to file a complaint against Robert in 2016. After some expansive but futile procedural maneuvering, the court held that the government’s claim was still valid, despite Schoenfeld’s death. It found that the government properly alleged in the amended complaint that Robert was the distributee of Steven’s estate. “[A]s the Personal Representative named in Steven’s will and the sole beneficiary of his Estate, Robert [was] a proper party to this suit.” Id. In reaching this decision, the court cited to United States v Park another recent decision along the same lines (U.S. v. Park, 16 C 10787, 2017 WL 4417826 (N.D. Ill. Oct. 5, 2017).

Now, it could be argued that this penalty ought to die with Mr. Higginbotham because it is punitive (i.e., penal) in nature and violates of the 8th Amendment to the U.S. Constitution. In fact, it is true that American courts have long recognized a well settled principle: that an action brought against a deceased party cannot continue “unless the cause of action, on account of which the suit was brought, is one that survives by law.” Ex parte Schreiber, 110 U.S. 76, 80 (1884). Further, they have long understood “that remedial actions survive the death of [a party], while penal actions do not.” United States v. NEC Corp., 11 F.3d 136, 137 (11th Cir. 1993), as amended, (Jan. 12, 1994). But while the Congress never specifically expressed its intention to ensure the FBAR claim survives death, the courts confronted with this question have found the FBAR penalty is remedial, not penal.

Quoting from the test instructed in Hudson v. United States, 522 U.S. 93, 118 S.Ct. 488, 139 L.Ed.2d 450 (1997), the NEC court found that a remedial action “compensates an individual for specific harm suffered,” whereas a penal action “imposes damages upon the defendant for a general wrong to the public.” The NEC Court found that Congress showed it preference FBAR penalties are civil by titling the statutory section as “Civil Penalties.” And despite the draconian nature of the penalty, the court astonishingly found little “evidence, much less the clearest proof,” that the FBAR penalty was “punishment.” The court noted that the BSA authorizes a penalty against all individuals who violate Section 5321, regardless of intent (known as “scienter”). And although the court found that Section 5321 promoted retribution and deterrence, emblematic of penal codes, it sluffed this aside decrying “all civil penalties [as having] some deterrent effect.” Id. The court found the FBAR penalty serves the additional alternative purpose of reimbursing the government for the cost of investigating and recovering the funds. Last, the court found that the FBAR penalty was not excessive in relation to this purpose. The likelihood that this will be challenged as prosecutorial aggressiveness pushes the civil towards the criminal is of no consequence to Mr. Higginbotham.

A gavel lying on spread-out money
Courts have found the FBAR penalty serves the additional alternative purpose of reimbursing the government for the cost of investigating and recovering the funds.

So, what is Mr. Higginbotham to do?

Mr. Higginbotham is presented with a Hobson’s choice. He can do nothing and let time and the vicissitudes of risk make the decision for him. As Abraham Lincoln once observed, “time is the greater quickener.” Or he can make a disclosure, either visibly or quietly. Each path is fraught with peril, made no less so by an underbrush of uncertainty obscuring both.

Doing nothing

Consider first, the pitfalls and perks of doing nothing, beginning with the pitfalls. Unfortunately, for Mr. Higginbotham, he bears an increasingly high risk, depending on his health, that the offshore account will be uncovered in his lifetime. This results from a confluence of technological advances, tectonic shifts in global information exchange culture and the aggressiveness with which the U.S. has use its increasingly lethal arsenal of punitive and informational weaponry. In fact, the IRS bragged about its enhanced digital tools for sniffing out those who are skirting the tax laws.2

Add to this that banks increased cooperation is a rational reaction to the perceived cost benefits, as high-profile cases get publicized. Indeed, the first well-publicized target was UBS in Switzerland who ultimately turned over the name of more than 4,000 U.S. taxpayers with Swiss accounts. UBS agreed to pay a $780 million fine as a result of its guilty plea to help American evade taxes. Indeed the U.S. government has even secured convictions of foreign bank executives for violating FATCA, sending a signal to the institutions that there is a human costs to shielding their U.S. customers.

Sensational stories of high-profile cases have also caused many taxpayers with foreign accounts to capitulate, and this has meant the IRS can focus limited resources on a smaller pool of violators. As of December 2012, the IRS had collected more than $5.5 billion in back taxes, interest and penalties from more than 39,000 taxpayers, according to the U.S. Government Accountability Office (GAO Rep’t 13-318). Since 2009, more than 1,500 have been indicted for crimes related to international activities according to the IRS (IR-2018-52).
And they are reacting rationally to the ruthlessness with which the government has pursued non-filing. While the Schoenfeld litigation was dramatic, another highly publicized case of U.S. v. Carl Zwerner proves age and infirmity serves as no barrier.

Eighty-seven-year-old Carl Zwerner opened an account in Switzerland in the 1960’s under the name of two different foundations he created. He used the proceeds for personal expenses, failing to report his financial interest in the Swiss bank account on a FBAR and any income earned on his original tax returns for 2004 to 2007. When a Southern District of Florida jury found that Zwerner willfully failed to file FBARs for the years 2004 through 2006, Zwerner faced a 2.2 million penalty on an account of less than 1.7 million. He ultimately settled the matter for $1.8 million in penalties and interest. See, U.S. v. Carl Zwerner, Civil Docket Case #1:13-cv-22082-CMA.

More bad news, of course, is that Mr. Higginbotham’s personal representative will likely have to deal with the issue, if he does not. Not only would the probate court require disclosure of these account, but the foreign bank would demand a power of attorney and perhaps more.

And at the same time, the institutional targets have been softened by global information exchange treaties, the U.S. Department of Treasury and Justice have hardened their blades and honed their craft. Behind every FBAR matter resolved by the IRS is a taxpayer who sat down with the IRS to divulge information. And therefore, there is an increasingly high risk that foreign banks and taxpayer will name other holders of foreign accounts, allowing Treasury and Justice to cast an ever-widening net. Because of collaboration, the number of jurisdictions still available for concerning assets has decreased with a concomitant increase in in attention to the few that remain.

In the event Mr. Higginbotham dies without the IRS discovering the accounts, there may be the glimmer of a silver lining. IRS private guidance issued of Oct. 22, 2007 (Cited in Journal of Tax Practice & Procedure by CCH) seems to suggest that if a personal representative files the FBAR for the first time on behalf of the estate, the representative is not expected to file all the FBARs the decedent should have filed. Of course, it is prudent that amended returns for the decedent be filed by the personal representative, which can be filed under any of the IRS’ voluntary disclosure options depending on the facts of the case. If the personal representative can show that he or she was not complicit in the failure to file, this practice of disclosure after death may yield a favorable result, although this is far from certain. It should be noted that voluntary disclosure after death was not something Mr. Schoenfeld or Zwerner availed themselves of.

Voluntary disclosure

Next, consider voluntary disclosure. For the past decade, the IRS has maintained a safe harbor for taxpayers who wanted to disclose offshore accounts that they feared may have exposed them to criminal penalties. This so-called Offshore Voluntary Disclosure Program (OVDP) was beneficial because – although the OVDP problem voluntarily subjected taxpayer to fines – thee fines were reduced. Moreover, the threat of criminal prosecution evaporated if the disclosure was timely. Over the years, tens of thousands of taxpayers have availed themselves of the program. But on Sept. 28, 2018, the IRS closed its OVDP program. Only taxpayers who submitted the required disclosures and materials no later than Sept. 28, 2018 could avail themselves of the program.

While time has run out on the OVDP program, Mr. Higginbotham may take advantage of a lesser known voluntary disclosure process. Long before the offshore program came into existence, voluntary disclosure was a policy of the IRS. Taxpayers with criminal exposure could potentially avoid criminal prosecution is they voluntarily came into compliance. See I.R.M. Known as the Streamlined Filing Compliance Procedures process, this avenue exists for taxpayers who have both failed to file their FBARs and to properly and timely report the income earned on their foreign financial accounts on their tax returns due to negligence, inadvertence or mistake. The procedures allow taxpayers, who meet certain eligibility criteria to get into compliance with fewer penalties. For nonresident taxpayer, there are often no penalties.

Whether or not Mr. Higginbotham can use this approach depends on the evidence. The key criterion is that that taxpayer’s noncompliance be non-willful. And to reduce false submissions, the IRS requires that the taxpayer certify, in detail, the facts supporting the non-willfulness.

Two cautionary points here deserve mention. First, should Mr. Higginbotham avail himself of this process, but yet submit a non-willful certification in doing so, he may be exposed to criminal prosecution under, among other things, 18 U.S.C. 1001 (the same statute Paul Manafort was charged with violating). The IRS will normally not settle a FBAR case without having a face-to-face meeting with the taxpayer (See, IRM Ex. 4, 4.26.16-2), where they will probe his theory of non-willfulness. There are other requirements as well. For instance, if the IRS has initiated a civil examination of taxpayer’s returns for any taxable year, regardless of whether the examination relates to undisclosed foreign financial assets, the taxpayer will not be eligible to use the streamlined procedures. Returns submitted under either the Streamlined Foreign Offshore Procedures or the Streamlined Domestic Offshore Procedures may be selected for audit

There are also “Delinquent FBAR Submission Procedures,” which are available to taxpayers who have reported their income earned in foreign accounts but who did not file the required FBARs. There is no guarantee, though, that the SFCP will remain open forever; and the IRS is encouraging those taxpayers who have offshore compliance issues who meet all of the qualifications of the SFCP to use that procedure while it is still available.

Stealth disclosures

There is one more option that is a hybrid. Mr. Higginbotham may make what is known as stealth disclosures, either a “quiet disclosure” or a “first time disclosure.” Under this first alternative, Mr. Higginbotham would file an amended tax returns and FBAR as far back as the statutes of limitation (e.g., three years or more) in the hope of avoiding assessment of even the smaller penalties. However, commentators do refer to this as a high-risk tactic as the cat has long been out of the bag. A Government Accountability Office report has flagged quiet disclosures as being on the increase and has urge the IRS to look for amended returns to better ferret out these quiet disclosures.

In a first-time disclosure, the Mr. Higginbotham would disclose the presence of the account on his return for the first time, hoping to bury the prior transgressions. However, “new disclosures” like “quiet disclosures” are not an unknown device to the IRS, which is casting a more jaundice eye upon the practice. As the Government Accountability Office has pointed out here, the number of taxpayers checking the “foreign bank account” box on Schedule B doubled between 2003 and 2010, while curiously during that same period, the number of FBA filed more than tripled.


Mr. Higginbotham finds himself in an unenviable position, as do all taxpayers who have offshore tax compliance issues after OVPD. It matters not whether they opened the foreign account for a nefarious or benign reason. Which course the law recommends to such taxpayers is not manifestly clear, and the IRS seemingly relishes in making it unclear, perhaps to warrant selective enforcement. Which course the facts recommend, in turn depends on the circumstances. But the sobering decision to disclose, how to disclose or to leave the entire mess to the personal representative is one that must ultimately be made by the taxpayer. Doing nothing is itself a decision. And if that path is taken, time and fortune will dictate the uncertain result. Rest in peace.


1 See,
2 See, “IRS Criminal Investigation chief Plans New Enforcement Programs,” Accounting Today (August 2, 2017).


Before the next crisis

A hand stopping some falling dominoes from continuing on to two more lines standing of dominoes

These should be the best of times. World poverty is at a record low, and world incomes are at a record high. People in most countries have never had greater economic opportunity and prosperity, yet a great disquiet is unsettling many around the globe.

Global net government debt is at a record high and growing. The great curse of democracies is that the people demand that their political representatives give them more “free stuff” in terms of healthcare, retirement and poverty protections, etc. Yet tax rates in many countries are already above the long-run maximizing rate. Responsible fiscal policies are evaporating country by country.

Populations are aging throughout the world, resulting in an increasing percentage of elderly who must be cared for by a shrinking proportion of working-age populations. Many are growing increasingly pessimistic about the debt/demographic dilemma.

Monetary policy seems to have hit a wall. During the Great Recession, major central banks greatly increased their holdings of government securities, without developing a coherent plan for unwinding what they had done. Traditional monetary policy is now dead!

I recently received a note from a colleague who is one of the best economists that I know and who has held a number of high-level government positions. He observed: “The entire system has become so illogical, so convoluted and built by repeated applications of flawed government policies attempting to solve previous problems created by government efforts to correct still earlier problems it created ad infinitum, that economic theory offers no explanations/predictions inside the limits.”

The only thing that is clear is that the present situation cannot continue forever. One can only speculate how it will end – a general collapse, a rolling readjustment (as has happened in Greece) country by country, or a wake-up in some key countries whereby some courageous and knowledgeable leaders are elected to effect the necessary fiscal changes.

In this issue, Dennis Richardson observes that the “Fed seems to be in a desperate race toward normalization before a downturn in the economy arrives so that it has some tools to help fight the recession. The Fed’s conundrum is whether it can achieve normalization without causing the economic downturn for which it is trying to prepare.” Richardson presents a brief history of how the Fed got where it is, and then reviews the various alternative actions the Fed can now take, including doing nothing.

The policy dilemma that U.S. policy makers are facing is modest compared to what the Japanese officials now confront. Orphe Pierre Divounguy gives what can only be characterized as a depressing overview of the Japanese situation. “For the past decade, Japan’s population has been declining. This decline has been driven by decades of extremely low fertility rates and a recent uptick in the number of deaths among the oldest population in the world.”

The working-age population is now declining, while entitlement spending on an aging population is increasing. The debt burden is already at world record highs, and any further increase in taxes will only slow growth even more, reducing real tax revenues and making the situation worse. Old-age pensions and entitlements need to be reduced, but this is a political non-starter as the young correctly understand that if the state is not taking care of their parents and grandparents, they will have to – resulting in a reduction if their living standards.

The Japanese situation is only a forerunner of what many of the world’s advanced economies are facing. Parts of Europe are now suffering from negative population growth, and it is only a matter of time before Europe as a whole and eventually even North America have a declining population. More dependent old people and few workers will lead in one way or another to falling living standards – with no obvious way out – other than increasing birth rates and cutting entitlements.

Various schemes by governments to increase birth rates, such as tax credits for children, have not shown great success where they have been tried. One of the ironies is that as pay between men and women increasingly reaches parity, the opportunity costs for a women to drop out of the work force to have children greatly increases – and a tax credit to fully offset this cost is likely to be so high as to undermine what is increasingly becoming a shrinking tax base.

To avoid cutting pensions, governments could do more to reduce or even eliminate other government programs, but each of these also has its own political constituency, which will resist any reductions – the education, medical, infrastructure and defense spending lobbies are not going to wither and go home without a fight.

A major target of those seeking to obtain more revenue for governments are “greedy” rich people and corporations, particularly those who shop the globe for tax advantageous reasons. Many of those in governments seeking to “get the rich” fail to distinguish between the negative effects of an increase in the tax on capital and one on consumption, leading to many unnecessarily destructive taxes.

As government tax officials have become more and more aggressive in their pursuit of tax avoiders and evaders, the personal and financial risk for taxpayers with “offshore accounts” has grown. Tax lawyer, Dan Mastromarco, describes the dangers and hoops that people seeking to close their accounts and otherwise avoid risk needs to go through in order to protect themselves. Part of the problem is that some of the rule changes are retroactive, so people who operated in good faith at some time in the past now find themselves liable for actions which seemed perfectly legal at the time. An even greater problem is the number of governments and their administrative organizations who now claim the right to demand data and forms from those who have financial accounts in more than one jurisdiction. The complexity has grown to the point where it is nearly impossible for any one person to know all of the things he or she may be required to do or all of the potential liabilities they may face.

And oh, by the way, your death may not absolve your heirs for being responsible for some of your tax and other alleged financial sins.

The good news is, as I noted in the first sentence, that the world is getting more prosperous, despite the best efforts of many of those in government to throttle success. History shows that many insolvable problems are indeed solved by very clever people – so do not despair and applaud the clever.

Offshore centers introduce substance legislation to stave off EU blacklisting

Cayman Financial Review Logo

Jersey, Guernsey, the Isle of Man, Bermuda, the British Virgin Islands, the Bahamas and Cayman have all introduced new legislation late last year requiring that companies that are tax resident in their jurisdictions have enough economic activity locally to justify the profits they make there.

The new laws resulted from pressure by the European Union to blacklist any countries that “facilitate offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction”

To avoid an immediate blacklisting and potential punitive measures, Cayman’s government and other jurisdictions made a written commitment in Dec. 2017 to introduce new substance requirements into legislation by the end of 2018.

Cayman’s ministry of financial services said the new requirements “could be fulfilled by activities such as hiring staff and having physical business locations; or outsourcing these activities to a local service provider.”

The International Tax Co-operation (Economic Substance) Law affects banking, insurance, fund management and shipping companies; entities functioning as headquarters or distribution and service centers; and businesses engaged in financing and leasing or holding intellectual property.

If a Cayman entity is conducting relevant business activities in one or more of these categories; and if that entity is not tax resident in another jurisdiction, the law would require the entity to have ‘economic substance’ in the Cayman Islands, the ministry said in a press release.

Resident companies that generate core income in the prescribed fields must pass the economic substance test from July 1, 2019.

They will do so, if they conduct core income-generating activities on island; incur an adequate amount of operating expenditure in Cayman; have a physical presence locally; and have an adequate number of full-time staff. In addition, the company must be directed and managed from Cayman with regular board meetings held and minutes of strategic decisions kept on island.

Equity holding companies are subject to a “reduced” economic substance test under the proposed legislation. They would satisfy the substance test if they have complied with all applicable filing requirements under the Companies Law and if they have “adequate human resources and adequate premises in the islands for holding and managing equity participations in other entities.”

So-called high-risk intellectual property holding companies, on the other hand, are subject to more onerous requirements.

They include companies that hold intellectual property they did not create and acquired either from an entity in the same group or another entity outside of Cayman, and then license the intellectual property to related entities.

They also encompass intellectual property businesses that do not undertake research and development, branding or distribution as part of their local core income-generating activities.
High-risk intellectual property businesses are presumed to have failed the substance test, even if they carry out core income-generating activities on island, unless they can demonstrate that they historically maintained control over the development, exploitation, maintenance, enhancement and protection of the intangible property asset. This would have to be exercised by an adequate number of full-time employees with the necessary qualifications that permanently reside and perform their activities in Cayman.

These types of businesses must provide detailed business plans which demonstrate the commercial rationale for holding the intellectual property assets in the islands; employee information, including level of experience, type of contracts, qualifications and duration of the employment; and evidence that decision making is taking place within the islands.

The new rules effectively force these businesses to demonstrate that they had a high degree of control over the development and exploitation of the intellectual property asset they hold, even if they already have economic substance locally.

Relevant companies must file a report with Cayman’s Tax Information Authority each year. If the authority deems that the company has not passed the substance test, it has the power to issue a penalty of $10,000. If the substance test is failed again in the subsequent year, the penalty increases to $100,000 and the company can be struck off.

Minister for Financial Services Tara Rivers said representatives from more than 15 financial services and commerce associations had participated last year in the government consultation on the new legislation.

The Cayman Islands government is expected to issue guidance notes and regulations after another round of industry consultations in the first half of 2019. However, it is not clear whether these will define what “adequate” economic activity means by setting minimum standards and thresholds for each individual sector.

The lack of minimum substance standards is designed to keep the legislation flexible for the unique circumstances of each type of business, but it also makes it difficult to quantify the economic impact of the substance test.

Premier Alden McLaughlin told fellow members of the Legislative Assembly in December 2018, “Companies that are here in an attempt to circumvent tax obligations elsewhere will have a choice: They can go back to onshore jurisdictions with direct taxation or they can increase their level of substance in Cayman.”

According to Premier McLaughlin, exact data is not available but rough estimates suggest up to 20,000 companies could fall under the law.

The BVI government has estimated that the substance legislation will lead to a 10 percent to 20 percent drop in its financial services business.

The different substance legislations in Cayman, the BVI, Bermuda and the Channel Islands are very similar in their approach because they are based on the work of the OECD Forum on Harmful Tax Practices (FHTP) which seeks to eliminate harmful preferential tax regimes.

These are regimes that apply tax incentives or concessions to taxpayers, who are engaged in operations that are purely tax-driven and involve no substantial activity.

Although none of the tax regimes in the Crown dependencies and British overseas territories are “preferential,” in the sense that a tax rate is reduced in certain circumstances, the OECD expanded the application of substance rules to all “no or nominal tax jurisdictions” under Action 5 of its OECD Base Erosion and Profit Shifting initiative.

The OECD justified the move with the concern expressed by countries who employed harmful preferential tax regimes that they might lose business to low tax countries now that they are forced to change their rules by implementing economic activity standards.

The EU subsequently notified all countries that failed its tax blacklist criterion of “facilitating offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction” that they should mirror the rules developed by the FHTP.

This has the effect that the rules developed for harmful concessionary and incentive-based parts of a tax regime are applied to these jurisdictions as a whole. In other words, it treats their entire tax regime as harmful. This leads to significantly higher compliance costs in low- or no-tax jurisdictions.

Netherlands puts low-tax jurisdictions on tax blacklist

The Netherlands has compiled a new list of 21 low-tax jurisdictions, including the Cayman Islands, to fight tax evasion. The list was published on Dec. 28, 2018, in the country’s government gazette.

It contains the five jurisdictions – American Samoa, the U.S. Virgin Islands, Guam, Samoa, and Trinidad and Tobago – that are currently blacklisted by the European Union.

In a sign that substance legislation, recently passed by several offshore jurisdictions to avoid an EU-wide blacklisting, will not be enough to appease EU member countries, the Dutch list also contains 16 low-tax jurisdictions. The only criterion for the list appears to be that these jurisdictions have a corporation tax rate of less than 9 percent or no corporation tax at all.

They are Anguilla, the Bahamas, Bahrain, Belize, Bermuda, the British Virgin Islands, Guernsey, the Isle of Man, Jersey, the Cayman Islands, Kuwait, Qatar, Saudi Arabia, the Turks and Caicos Islands, Vanuatu and the United Arab Emirates.

From Jan. 1, 2021, companies registered in blacklisted jurisdictions will be subject to a 20.5 percent withholding tax on interest and royalties received from the Netherlands. In addition, Dutch tax authorities will no longer issue advance tax rulings on transactions with companies headquartered in blacklisted jurisdictions.

In its implementation of EU Anti-Tax Avoidance Directives, the Netherlands will go beyond prescribed minimum standards with stricter controlled foreign company rules and special measures to prevent earnings stripping and hybrid mismatches that attempt to exploit differences between tax systems.

The Cayman Islands government rejected the blacklisting stating the list was based on the sole criterion of those jurisdictions having a lower corporate tax rate than any EU member state.

“This ‘blacklisting’ does not take into account Cayman’s demonstrated adherence to international standards for tax transparency, or participation with the OECD’s BEPS Inclusive Framework, and ignores our engagement with the EU’s Code of Conduct Group over the last two years to address their concerns regarding economic substance,” a government statement said.

The government described the blacklisting as “unjustified” and “lacking in fairness and credibility.”

“It is unfortunate that the Netherlands has chosen to attempt to divert criticism of its own tax practices by attacking the legitimate tax regimes of other jurisdictions,” the statement continued.

The Netherlands itself has come under criticism for operating a tax haven for international corporations, which use the extensive international treaty network of the country with 150 double taxation agreements to shift profits to low-tax jurisdictions.

A recent study by government agency Statistics Netherlands found that the country had received 4.6 trillion euros (US$5.2 trillion) in “foreign direct investment” in 2017.

However, less than a fifth of that money – $836 billion – remained in the Dutch economy, while $4.2 trillion was routed through shell companies to other jurisdictions. Researchers said about a third of the money ended up in “offshore tax havens.”

IMF data, reported by academic Jan Fichtner in the Cayman Financial Review in 2017, shows that in 2015 Cayman entities received $53 billion in foreign direct investment from the Netherlands, and $49 billion were sent in the opposite direction.

FCO: Beneficial ownership register to be made public by 2023

The U.K. has indicated that it will issue an order in council instructing British Overseas Territories to establish fully operational public registers of beneficial ownership by 2023, if they have not done so by the end of 2020.

The U.K. revealed the timeline in discussions with the Overseas territories at the Joint Ministerial Council in Dec. 2018.

The House of Commons passed the Sanctions and Anti-Money Laundering Act in May, including a controversial opposition amendment calling for the U.K. government to force Overseas Territories to make information on the owners of companies and other entities registered there available to the general public.

British lawmakers believe having this type of information accessible on the internet would help in the fight against tax evasion, money laundering and financial crime.

Although most of Britain’s 14 Overseas Territories, including Cayman, have beneficial ownership registers that grant access to British law enforcement and tax authorities, the registers are not public.

The Cayman Islands government has described the action by the U.K. parliament as “a potential constitutional overreach” as it touches on financial services, an area of policy that is devolved to the territory. The government announced that it would therefore mount a legal challenge to such an order if it were ever made.

In addition, the government has held constitutional talks with the Foreign and Commonwealth Office seeking to introduce constitutional safeguards that would confirm that the Cayman Islands government has autonomous capacity in respect of domestic affairs, and that the U.K. will not seek to legislate, directly or indirectly for the Cayman Islands without consultation.

Data Protection Law start date pushed back

Government is delaying the enforcement of the Data Protection Law, originally slated for Jan. 1, 2019, by nine months following representations made by the financial services industry.
The Data Protection Law regulates how businesses and government agencies must handle all personal data in the Cayman Islands and provides a framework of rights and duties designed to give individuals greater control over their personal data.

The law specifically covers how such data is collected, processed, stored or transmitted, particularly when dealing with government bodies, corporate entities, practices and firms.
The new commencement date of Sept. 30, 2019, is aimed to enable all entities impacted by the new law to be ready to meet its requirements.

Attorney General Samuel Bulgin said stakeholders in the financial services industry had sought more time to better prepare themselves for complying with the law. This included the completion of staff training, hiring new staff as needed, auditing existing data and establishing the needed administrative framework.

“Government is hoping that the new starting date will allow all impacted by the law, including data controllers and employers, small and big, in the public and private sectors, sufficient opportunity and time to prepare and be able to comply with the requirements,” Bulgin said.

The rotten smell of the European tax agenda for 2019

Chart 1

With European economies in a slump and the discussion about the Brexit dominating headlines, taxation was not among the hot issue during the last couple of months. It would, however, be a mistake to assume that the pressure exerted on taxpayers in the context of the BEPS-related reforms is going to recede. On the contrary, it seems quite reasonable to assume that the adverse economic conditions will cause European politicians to scramble to obtain additional resources in their efforts to pacify a disgruntled constituency and keep the inflated welfare state afloat. It is indeed most curious (but maybe that is just my perception) that the political debate in Europe remains myopically centered on the distribution of income (including “fair” taxation) rather than on (finally) implementing structural reforms targeted at enhancing competitiveness.

In my previous contribution to CFR1, I touched on the issue that financial ministries and tax authorities in Europe are no longer primarily concerned with minimizing aggressive tax structures by modifying existing principles and regulations but are rather looking for ways to generate additional revenues by implementing entirely new taxation schemes. As shall be illustrated below, the current developments in Europe strongly suggest that that the EU as well as individual member states are poised to continue their aggressive stance when it comes to taxing multinational enterprises (MNEs). While the focus of this contribution will be on “digital taxation,” I will also briefly outline some general thoughts on tax policy in Europe and the optimal prerogative devolution.

Digital taxation – implementation at the national level is imminent

As previously highlighted2, the European Commission, issued a policy proposal in the Summer of 2018 to “reform corporate tax rules.” The intention of this proposal is to enable member states to tax profits that are (allegedly) generated in their territory, even if a company does not have a physical presence there – based on a so-called “digital presence” or “virtual permanent establishment,” which is deemed to exist when certain criteria (turnover or user based thresholds are exceeded) are met. The Commission was estimating that 5 billion euros in revenues a year could be generated for member states if the tax is applied at a rate of 3 percent. The objective of my previous contribution was to emphasize that the proposed policy was misguided and ultimately, nothing but arbitrary expropriation. Fortunately, the policy proposal made by the Commission failed to generate unanimous support among member states – due primarily to “staunch opposition” from (amongst others) “Denmark, Sweden, and Ireland, who have resisted targeting the revenues, rather than profits, of tech companies on their soil” (reported in the FT online by Kahn/ Brundsen, Dec. 4, 2018).

While the scrapping of the original policy proposal is unambiguously good news, no one should be surprised to learn that a watered-down alternative is already on the table – championed by France and Germany. The new proposal aims to taxing a narrower scope of digital activities (i.e. mostly focused on advertising), with the effect that “Facebook and Google would be targeted through their sales of advertising but other big tech companies, such as Amazon, Airbnb and Spotify, were likely to be excluded” (see FT cited above). The estimate of additional tax revenues has been correspondingly slashed in half.

While it is doubtful that even the watered-down alternative will facilitate a compromise among member states, there is little reason to rejoice. First, while the scope of this ill-conceived policy proposal is cut in half, the underlying principle remains bad and subsequent extension of the scope cannot be ruled out. Second, quite a few member states are implementing their national versions of a digital tax which potentially could feature (in variations) comparatively broader scopes. After the U.K., Spain and Italy declared their general intention to impose new national-level taxes for the digital economy, Austria has now followed suit and is expected to present its digital tax policy in January. Austrian Chancellor Sebastian Kurz proclaimed that “In addition [to] the European Plan […] we will take a national step. We will introduce a digital tax in Austria. […] the aim is clear: taxation of companies that make large profits online but barely pay taxes – such as Facebook and Amazon.” Explicitly targeting Amazon already indicates that the Austrian policy will feature a rather broad scope. It also illustrates the arbitrary nature of the tax; i.e. targeting individual (mostly U.S.-based) companies, instead of modifying general tax regulations.

Why improving ‘soft law’ is preferable to discussing the optimal prerogative devolution
For adherents of neoliberal policies (myself included), the developments summarized above are somewhat challenging. Possessing a deeply imbued distrust of the centralization of political and economic power, we intuitively tend to favor national over supranational solutions. To be clear, centralizing taxation policy at the EU level would be disastrous (as highlighted in all of my previous contributions to CFR, specifically those discussing the Common Consolidated Corporate Tax Base). At the heart of discussing the prerogative devolution is the analysis of the trade-off between the benefits of centralization, arising from the economies of scale or externalities, and the costs of harmonizing policies in the light of increased heterogeneity of preferences in a large union (as often discussed by A. Alesina in the context of assessing the status of European integration – in my interpretation the approach comes quite close to Hayek’s general position in Europe as well).

Considering the lack of consensus among the member states is rather evident, we arguably do not have to dwell on the prevailing heterogeneity of preferences. The extent of externalities, which in the case of tax evasion is arguably (approximately) measurable as the resulting tax gap, is often blown out of proportion. In the case of digital taxation, however, one may justifiably conclude that there exist no externalities at all, i.e. there is no tax gap.

The policy proposal of the EU Commission is not based on the notion that the digital tax is needed to curb tax evasion (or avoidance) of Amazon & Co., but rather that there is economic activity which is (allegedly) untaxed and is perceived as inherently unjust. This perception is highly influenced by the notion that the “value of things” depends on how (where) people use them. Leaving the theoretical discussion of “value” aside, it seems quite absurd to define the existence of an (presumably) untaxed Facebook or Amazon account as an externality. Lastly, member states are clearly able to introduce (and implement) a digital tax on the national level. In sum, the analysis of the trade-offs clearly illustrates that there are no convincing arguments for allocating the prerogative for digital taxation to the EU level.

So, if individual member states want to implement additional taxes that further weaken their competitive position and harm local consumers, (let them) it is certainly preferable to contain the adverse effects to the national level.

Considering the detrimental impact of a digital tax as such, however, it does not seem quite adequate to be content with the prerogative being allocated to the national level. Bad policy is policy. The question I am asking myself in this context is how to convince policymakers to refrain from implementing additional taxes or more restrictive regulation. Ultimately, it will be crucial to chance the perception of MNEs as being habitual tax avoiders and tax authorities as being the magnanimous and objective servants of the common good. One sensible piece of the conversation could be to advocate that the OECD, as supra-national organization, is well-positioned and actually doing a credible job in ensuring efficient tax policy framework within the existing global consensus (i.e. applying the arm’s length principle as the international paradigm for transfer pricing). I have previously argued that BEPS is likely to “work out” in the sense that aggressive tax avoidance schemes are curbed, and taxation of profits will be closer aligned with value creation (economic activities). 2019 will see further interesting milestones, as the guidance for financial transactions as well as for centralized services will be updated. Tax avoidance is being addressed and “soft law” (a modernized guidance for applying the arm’s length principle) is a much more promising approach than hard law (or taxing revenues) be it on European or national level. In other words, European policymakers should leave well enough alone.

Many neoliberals have a hard time accepting that the OECD can actually play a positive role. It has been said that BEPS is a concerted effort by high tax countries to sustain (and expand) their tax bases. There is certainly merit to this assessment. The pragmatic question in this context, however, seems to be whether accepting the OECD as a facilitator of soft law is the lesser of two (multiple) evils. Embracing the arm’s length standard as a sort of “meta regulation” is extremely beneficial – i.e. while different national tax rates will continue to apply (tax competition is preserved), taxpayers can trust that the different national tax authorities will at least base their assessments on the same overarching principle. While double-taxation may (inevitably) persist, it will be much lower compared to a situation in which national tax authorities apply differing (irreconcilable) principles when taxing the income – and some member states adding a (digital) tax on revenues resulting from economic activity that is already subject to income tax.

Soft law is sufficiently effective – Amazon is paying taxes based on local activities

When writing this contribution, I got the feeling that my plea for the ALP might be getting old. While I will never relent, I want to conclude by further substantiating my above arguments that the allegedly untaxed digital activities of Amazon & Co. do not result in externalities – let’s just take a look at (some of) the operations of Amazon in Germany. The following table summarizes the tax positions of (some) Amazon subsidiaries operating in Germany: See chart 1Chart 1

The financial data shown in the above tables can be considered as being representative for local subsidiaries performing routine functions. These entities perform support activities (in the case of the above entities; web-services, logistics and contract development) requiring no unique and valuable intangibles. The strategic leadership and required intangibles are contributed by the Amazon headquarters. It is no coincidence that the local entities exhibit comparatively low but stable profits (EBIT ratios of 5 percent for web-services and logistics and 8.5 percent for development). Assuming that the routine classification can be substantiated, the profitability ratios realized by these German subsidiaries are compliant with the arm’s length principle.

Commensurate with the low value-adding nature of the services contributed the German entities receive an almost “guaranteed” (i.e. isolated from market risks) remuneration, while the residual profits (and losses!) are attributed the group entity(or entities) responsible for the strategic leadership and for contributing the unique and valuable intangibles – presumably Amazon headquarters. From a German perspective the economic value added contributed by the local entities is numerated and taxed appropriately – there is no indication of tax avoidance or of an untoward low tax rate (in fact Amazon pays quite a healthy share of taxes on revenues realized by the local entities). Most certainly, based on the above data, there is no indication that the activity of Amazon could be deemed as constituting an externality from a German perspective. Admittedly, the above data does not allow any conclusions in respect to the arm’s length nature of the allocation of profits relating to the intangibles. But, if anything, this is exactly the issue that was targeted by the BEPS project; i.e. the transfer pricing regulations were modified to ensure that the profits relating to intangibles will be allocated based on economic contributions rather than legal ownership.
So, just maybe, Mr. Kurz and other European policymakers should take a second look at the contributions made by Amazon and other MNEs to the local economies before they embark on introducing local (national) regulations that go “beyond BEPS.” And, also just maybe, some of their economic advisors will point out that taxing digital revenues of (arbitrarily selected) tech companies is not a policy that is likely to facilitate economic growth.


1 Cayman Financial Review 4th Quarter, Issue 53, pp. 56
2 Cayman Financial Review 3rd Quarter, Issue 52, pp. 44

The population bust: Demographic change and the coming fiscal crisis

Figure 3: Since the 1960s, growth in the world’s retired population has increased by 17 percent

Japan’s Prime Minister Shinzo Abe opted to raise the sales tax in order to shore up government finances in addition to taking steps to increase immigration in light of the country’s shrinking tax base.

For the past decade, Japan’s population has been declining. This decline has been driven by decades of extremely low fertility rates and a recent uptick in the number of deaths among the oldest population in the world.

Japan’s young (under 15 years of age) and working-age (15-64 years old) population growth rates have turned negative. With a declining workforce, and a 65-and-over population that is growing at an average rate of 2.5 percent per year, the pressure on government finances – due to rising entitlement spending coupled with a shrinking number of taxpayers – has prompted authorities to enact a number of programs to make having children more appealing for young adults.

An aging population and the decline in Japan’s workforce have had serious consequences for economic growth and government finances. The rapid aging of Japan’s population has raised the cost of medical care services; resulted in a serious shortage of a young workforce; and led to a decline in demand as evidenced by houses that become and stay vacant, and in the growing number of municipalities that face “local extinction.”

But Japan is not alone. Many of the world’s most advanced economies will soon face a similar fate.

According to data from the World Bank’s World Development Indicators, the world’s population is aging fast. Population aging raises the number of elderly people relative to the number of working-age people, when we hold the age boundary constant at some level such as age 65. In this sense, population aging occurs partly because individuals live longer, and partly because birth rates are lower, so that younger generations are smaller than older generations.

Since the late 1980’s the world’s older population (mostly retired individuals, 65 years old and over) has grown at a faster rate than the world’s potential workforce. During the past decade, the world’s working-age population has grown at an average yearly rate of 1.1 percent. The population entering retirement age has grown at nearly three times that rate during that same period. See figures 1, 2, and 3

Lower growth of the population’s youngest cohorts means that the median age is increasing and that the world is aging fast. This structural change in the age of the population has been even more pronounced for some of the world’s most advanced economies, notably the U.S., Canada and the Euro-area.

An aging population has serious implications for economic growth since economic growth crucially depends on the quantity and quality of workers. As people age and leave the labor force, economic growth is expected to slow.

Figure 1: The number of retired individuals per worker is increasing

Figure 2: Since the 1960s, growth in world’s workforce has fallen by 40 percent

Figure 3: Since the 1960s, growth in the world’s retired population has increased by 17 percent

How demographic factors affect economic growth and tax revenues

Income and spending patterns change over the lifecycle and the impact of these changes on economic growth and tax revenue can be substantial. Earnings increase during a worker’s career and then fall in old age. Similarly, consumer spending tends to increase as people move from early life to middle age, and then spending declines after retirement. The effects of these changes in income and spending have significant implications for economic growth and tax revenue since most governments rely heavily on income and sales taxes.

The experts agree: recent demographic trends explain much of the decline in economic growth and in the labor share of income. A decrease in population growth leads to fewer new investments, and fewer new firms being created such that large firms now account for a greater share of economic activity. This concentration of employment in large firms can explain the decline in the labor share of income.

A number of economists argued that expected structural economic changes – including adverse demographic developments – have led to a persistent decrease in the propensity to invest coupled with the oversupply of savings. In this context, excess savings act as a drag on growth and inflation resulting in economic stagnation and lower real interest rates.

Traditionally societies invest to provide new equipment for young workers and to provide new housing for young families. Unfortunately as the number of new workers and new families falls, the demand for new business capital and housing capital also falls. Despite falling investment demand, middle-aged workers tend to increase their savings due to longer life expectancy. Declining fertility rates combined with longer life expectancy work together to depress investment while pushing up savings. The result has been lower economic growth and declining real interest rates.

The demographic shift may have already caused a decline in real GDP growth and in the equilibrium real rate by 1 to 1.5 percentage points.

Lower economic growth is associated with lower tax revenues and more severely underfunded pension systems

Economic growth is a major driver of the level of tax revenues. If the economy is growing slower, tax revenues will also increase a slower pace. This means that the likelihood of a budget deficit increases and that pension systems funding ratios could also decrease. This is because a shrinking workforce, combined with a growing old-age dependency ratio, is expected to negatively affect tax revenues while raising public healthcare and pension costs. Lower growth coupled with prolonged periods of low interest rates have contributed to disappointing returns for pension funds.

It is a spending problem, not a revenue problem

Demographic trends suggest that the global economy and that tax revenues are not likely to grow very fast in the future. However, in the United States, even the most robust growth in historical terms is not sufficient to keep up with the growth in entitlement spending.

In the United States, social security, Medicare and institutional Medicaid and for the time being, “Obamacare” already make up more than 70 percent of the federal budget according to the Congressional Budget Office. As more individuals leave the workforce and life expectancy continues to increase, entitlement spending is expected to grow even faster.

According to Harvard University economist Jeffrey Miron, the U.S. fiscal imbalance – the excess of what we expect to spend, including repayment of our debt, over what government expects to receive in revenue – stood at $117.9 trillion as of 2014, with few signs of future improvement even if GDP growth accelerates or tax revenues increase relative to historic norms. Thus the only viable way to restore fiscal balance is to scale back mandatory spending policies, particularly on large health care programs such as Medicare, Medicaid and the Affordable Care Act (ACA).

Unfortunately, political expediency means that taxes have been raised instead of reforming unsustainable entitlement programs (state and local governments also face future crises, though this is mostly because of underfunded public employee pensions).

But, higher tax burdens will not fix the problem. In fact, higher tax burdens relative to historic norms will exacerbate the problem.

Unfortunately, politicians prefer tax hikes to spending reform. Raising taxes seem like a simple (a bit naïve) solution since tax rate changes have important consequences for economic growth.

While demographic forces have contributed to a decline in investment resulting in lower economic growth, a large body of empirical research suggests that tax hikes have also deterred investment and resulted in large declines in output. That means that any increase in the tax burden would only exacerbate the problem.

Individuals adjust their investment and consumption patterns in response to changes in the tax burden. An increase in the tax burden is likely to cause individuals and businesses alike to alter their financial portfolios, to alter their charitable donations and investment decisions, to reduce their labor supply or simply to leave a tax jurisdiction altogether to avoid increased tax burdens. Those who are most likely to alter their behavior in response to higher taxes are high-income individuals. That means that populist appeals to “tax the rich” would ultimately end up even more devastating for economic growth.

The high responsiveness of investment to changes in the tax burden indicate that new taxes could not provide a long-term solution to the coming fiscal challenges since economic growth would be even more sluggish, and returns on retirement savings would remain low.

The real solutions remain entitlement reform and binding spending rules

Given the reality that economic growth is likely to remain low relative to historic norms, there are only two serious ways to deal with the coming fiscal crisis: 1) to reform entitlements and 2) to enact rigid fiscal rules such as a spending cap.

While some countries are preparing for the coming population bust, others are refusing to enact the necessary reforms to deal with the coming crisis. More and more countries have introduced automatic adjustment mechanisms to rebalance pension systems in line with recent demographic and economic developments. A large part of the solution is to freeze the level of future benefits and to re-align them with what current and future taxpayers can afford. There is also a growing move by many governments to promote and even at times, subsidize private retirement savings.

But, none of these changes will be enough without spending restraints.

The fear of a looming debt crisis has a negative effect on investment depressing economic growth further, leaving retirees with less than adequate retirement income. Policies that stimulate economic growth must be part of the solution.

Using data from 29 countries, research by the International Monetary Fund (IMF) reveals that fiscal rules have led to stricter prioritization and greater efficiency in spending. When expenditure rules are written into law and not just a mere political commitment that can easily be broken, they are associated with spending control and improved fiscal discipline.

The benefits of strict expenditure rules are two-fold: 1) they reduce the volatility of expenditure, thus imparting a degree of predictability to fiscal policy and making it less destabilizing and 2) expenditure rules are associated with higher public investment efficiency.

While recent demographic forces have acted to depress the propensity to invest, higher public sector efficiency would free up resources for more high quality public investments that raise aggregate demand and raise labor productivity.

A spending cap would raise public sector efficiency, an essential part of the solution to offset the negative effect that recent demographic trends are having on economic growth and living standards.

Orphe Pierre Divounguy is the Chief Economist at the Illinois Policy Institute, a libertarian think-tank based in Chicago, Illinois. He is also the founder of the Quantitative Policy Group based in England.

Federalism, Australian Style: Federal-state financial socialism

Australia graphic - satellite image of the country given a 3D effect

There has been a lot of public debate this year in Australia about the federal system of government, in general, and, in particular, the system of payments between the national level of government and the sub-national level. Australia has a federal system of government similar to countries like the USA and Canada. Like the U.S., there is a national government and sub-national governments called the states and territories. Like Canada, these sub-national governments are a relatively small in number and population compared to the U.S. and include territories. Australia has six states and two territories compared to Canada’s ten provinces and three territories remembering of course that the U.S. has fifty states plus sixteen territories. The Australian national government is called the “Commonwealth”.

Three Aussie states are strongly complaining that it is largely unfair and unreasonable that they respectively and collectively do not get nearly enough revenue back from the Commonwealth for the Goods and Services Tax (GST) collected from their respective residents. Three other states and two territories are strongly of the opinion that it is mostly fair and reasonable that they get way more back in GST than they respectively and collectively pay. The complainants are New South Wales (NSW), Victoria and Western Australia (WA). The former two have been GST creditors for decades, whilst WA only became one in relatively recent years. The GST debtors are Queensland, South Australia (SA), Tasmania, the Australian Capital Territory (ACT) and the Northern Territory (NT). Of course, the creditors are really net tax-payers, the debtors are actually net tax-consumers, and the financial intermediary of the Commonwealth is in fact a tax-and-redistribute intermediary not a financial one.

A recent Sydney Morning Herald1 story nicely summarises the situation between the multiple warring parties: “[Commonwealth] Treasurer Josh Frydenberg has accused the states of playing politics with the GST, as NSW and Victoria call on the Morrison government to ensure ‘no state will be worse off’ under its $7.2 billion package. Victorian Treasurer Tim Pallas [has] demand[ed] Prime Minister Scott Morrison legislate that no state will be worse off under the changes, which will see a floor of 75¢ per person per dollar of GST and a six-year formula transition period put into law. NSW Treasurer Dominic Perrottet has gone further [when he] said his government believes ‘that it’s not fair that NSW continues to subsidise inefficient states as well as states like Western Australia who do not plan for future downturns to their economies.’”

Vertical fiscal imbalance (VFI)

The introduction of the GST in 1999 may have somewhat improved the longstanding vertical fiscal imbalance (VFI) between the Commonwealth and the states and territories, but at the expense of a more permanent entrenchment of VFI. The Productivity Commission (PC)2 defines VFI as: “The situation where the Commonwealth raises more revenue than it requires for its own direct expenditure responsibilities, whereas [states and territories] raise less revenue than they require for their expenditure responsibilities.”

VFI started in 1901 upon federation with the states giving up tariffs to the Commonwealth. The next big step in VFI was when they gave up income taxes during World War II. The third was GST, which is levied by the Commonwealth for spending by the states and territories. The latter also raise their own revenues through payroll taxes, mining royalties, stamp duties and land taxes. The PC documented VFI early this year in the following graph, noting that Australia has higher VFI than say Austria, Canada, Germany and the US but lower VFI than for example Belgium and Mexico: See figure 1

Figure 1 - Vertical fiscal imbalance

Horizontal fiscal equalization (HFE)

Besides the mismatch between the raising and spending of GST revenue at the national and sub-national levels, known as VFI, there is a further mismatch of revenue and expenditures across sub-national levels, known as horizontal fiscal equalization (HFE). The Commonwealth Grants Commission (CGC)3 defines HFE as: “The transfer of fiscal resources between jurisdictions with the aim of offsetting differences in revenue raising capacity and the cost of delivering services. Its principle aim is to allow sub-national governments to provide similar standards of public services at a similar tax burden.”

The key to HFE is relativities. Each year, the CGC assigns a relativity number less than 1.0 to creditor states or territories and greater than 1.0 to debtor ones, with the aim of being a zero sum game of sorts. As the PC has described it in a 2018 inquiry report into HFE: “Relativities reflect differences between state and territory fiscal capacities, both the revenue and expenditure sides, and this includes those factors outside state/territory control (know as disabilities) that increase its costs of delivering services relative to the average or that hinder its ability to raise revenue. Frequently, and erroneously, these relativities are referred to as the share of GST returned to a state or territory compared to the amount that was collected or generated by, or in, that jurisdiction.”

If all of states and territories were to receive GST on an average or equal per capita (EPC) basis then that would be like them all getting a relativity of 1.0. As can be seen in Figure 1.1 below, NSW and Victoria (at less than 1.0) have been carrying the other states and territories (at greater than 1.0) for more than 20 years. WA has swopped from the latter to the former over the past 10 years. GST payments are the single biggest payment from the Commonwealth4 to the states and territories at $63.4 million in 2017-18 or 52 percent out of a total of $122.4 million in that fiscal year. Figure 1.2 below shows the cumulative gap in total Commonwealth payments to the poorer and smaller states over the richer and bigger states of NSW and Victoria. See figure 2 and 3

Figure 2 - Divergence in State per capita relatives

Figure 3 - Cumulative distribution of all Commonwealth grants to States

The annual CGC process of HFE has been likened by many to a “black box” of overly onerous input data and overly complex calculations. The process has the following broad stages of assessing: 1) initial fiscal capacity; 2) average fiscal capacity; and 3) strongest fiscal capacity; plus redistributing: 4) most of the GST based on 1, 2 and 3; and 5) remainder of the GST based on EPC. Fiscal capacity is a somewhat fictitious and static concept of average and uncontrollable revenue raising and budget spending by each state and territory.

Prospects for reform

The PC publicly released the final report on HFE in July 2018, upon a year of inquiry and after providing the Commonwealth with this report in May along with recommendations for reform. The key recommendations included: “The objective of the HFE system should be refocused to provide the States with the fiscal capacity to provide services and associated infrastructure of a reasonable (rather than the same) standard. The CGC should immediately and systematically make the data provided by the [states and territories] publicly available on its website, along with the CGC’s calculations on these data. Reforming HFE in isolation will only go a small way to improving federal financial relations [and thus] there is a need to revisit the broader [federalism] environment in which HFE takes place, and to renew efforts to reform [this].”

The Commonwealth5 officially and publicly provided an interim response to the PC in July, when the current Prime Minister of Scott Morrison (nickname ScoMo) worked for former PM Malcolm Turnbull as the Treasurer. Turnbull was replaced as PM by Morrison6 in late August. It is not yet clear if the following Commonwealth response and three-step reform plan will change: “The Government’s plan involves transitioning to a new HFE system over eight years from 2019‑20 to 2026-27. The Government proposes to accept the PC’s recommendation to move to an updated reasonable equalisation standard. Instead of the PC’s proposed model of equalising [states and territories] to the average of all, the Government’s preferred model involves moving to a benchmark that would ensure the fiscal capacity of all is at least the equal of NSW or Victoria (whichever is higher). [In step 1] the Commonwealth would provide short-term funding over the three years from 2019-20 to 2021-22 to ensure that no [state or territory] receives less than 70 cents per person per dollar of GST. [In step 2] a within-system GST floor would be introduced in 2022-23 to ensure no [state or territory] can receive any less than 70 cents per person per dollar of GST [and] this floor would be raised to 75 cents in 2024-25. [In step 3] the Commonwealth Government would continue to boost the GST pool to ensure that all states and territories would be better off [and the] 0.75 within-system relativity floor would [become] a permanent feature of the HFE system.”

This response did not properly address some of the major economic findings by the PC such as:
“Despite the CGC’s aspiration and endeavour, Australia’s HFE system is not policy neutral. State [and territory] policy decisions can and do influence the share of GST revenue flowing to each. On the revenue side, changes in one [state or territory’s] tax rates [can] have a [substantial] impact on GST shares in some circumstances such as large tax reforms where one departs from what other ones do on average or where one policy has a significant influence on the size of a tax base (such as mining activity). On the expenditure side, changes in [state or territory] policy can affect GST shares though the potential to do so is much lower than on the revenue side [noting that] a greater driver is accountability which is lacking due to [VFI] and blurred funding responsibilities. The modelling results available suggest that the size of HFE’s impact on interstate migration of labour is small. [However] model outcomes are largely driven by assumptions of whether HFE is good or bad for efficiency, rather than having this determined by the model itself. [One school of thought] is that HFE dulls economic signals for labour and capital to move to where they are most productive.”

International federalism lessons

Wikipedia7 defines federalism as a “mixed or compound mode of government combining a general government (ie the central or federal government) with regional governments (eg provincial, state or other sub-unit governments) in a single political system” or as a “form of government in which there is a division of powers between two levels of government of equal status”. Wikipedia also displays a world map showing two-dozen “federations” and the rest as “unitary states” as well as a map of Europe showing seven “federations” and the rest as “unitary states” plus “devolved states”. The U.K. is an example of a devolved state into lesser regional governments of Scotland, Wales, Northern Ireland and London (but not England itself).

Other OECD countries were also assessed this year by the PC in terms of the HFE inquiry. The PC found that: “OECD countries exhibit considerable variation in the extent to which their equalisation schemes seek to [fully or partially] reduce fiscal disparities among sub-central governments. Although full equalisation [as pursued in Australia] largely eliminates fiscal disparities between sub-central governments, partial equalisation (as pursued in most OECD countries) allows for greater emphasis to be placed on other criteria such as efficiency, transparency, accountability, simplicity and predictability. While [EPC] fiscal capacity of sub-central governments is often used as the benchmark to guide equalisation, the methods of equalisation and the outcomes achieved under the alternative systems differ considerably.”

The PC, in particular, examined the HFE situation in Canada, Germany and Switzerland. The PC concluded regarding these three OECD countries that:“Canada seeks reasonably comparable levels of public services at reasonably comparable levels of taxation across provinces. Provincial governments with below-average fiscal capacity are equalised up to the Canadian-average fiscal capacity, but provinces with above-average fiscal capacity neither receive payments nor are required to contribute. Germany aims to equalize the differences in financial (revenue raising) capacity of states or Länder. Länder with below-average fiscal capacity are levelled up towards the German average, while Länder with above-average fiscal capacity are levelled down. Switzerland looks to provide minimum acceptable levels of certain public services without much heavier tax burdens in some states or Cantons than others. Equalization payments aim to provide each Canton with a minimum per capita financial resource level of 85 percent of the Swiss average.”

Buy, sell or hold

Australia’s system of HFE is a “sell”, even if new PM Morrison undertakes reforms more closely in line with those suggested by the PC rather than those flagged by former PM Turnbull. As the Institute of Public Affairs (IPA) has pointed out regarding Aussie HFE: “The equalization process creates damaging incentives for state governments to avoid undertaking necessary pro-growth reforms, and compounds the central problem affecting state government finances – namely the near complete loss of state fiscal autonomy. The solution to Australia’s GST problem is to restore fiscal autonomy to the states. This would unlock the benefits of competitive federalism, as exists in countries like the United States and Canada.”

HFE incentivises high taxation and even higher spending at the expense of economic growth, for not just the poor performing states and territories, but ultimately for all, including making VFI worse. As the great Chicago School economist Milton Friedman9 has shown – incentives matter:
“A simple classification of spending shows why [government redistribution] leads to undesirable results. When you spend, you may spend your own money or someone else’s; and you may spend for the benefit of yourself or someone else. Combining these two pairs of alternatives gives four possibilities summarized in the following simple table [below]. Category I in the table refers to your spending your own money on yourself. You clearly have a strong incentive both to economize and to get as much value as you can for each dollar you do spend. Category II refers to your spending your own money on someone else. You have the same incentive to economize as in Category I but not the same incentive to get full value for your money, at least as judged by the tastes of the recipient. Category III refers to your spending someone else’s money on yourself. You have no strong incentive to keep down the cost, but you do have a strong incentive to get your money’s worth. Category IV refers to your spending someone else’s money on still another person. You have little incentive either to economize or to try to get value most highly. All welfare programs [like HFE] fall into either Category III or Category IV.”

The “E” in HFE stands for “equalization”. Such a goal is, intentionally or unintentionally, based on the socialist ethic of equality. To paraphrase the great Austrian School economist Murray Rothbard10 –equality destroys: “Compulsory equality will demonstrably stifle incentive, eliminate the adjustment processes of the market economy, destroy all efficiency in satisfying consumer wants, greatly lower capital formation, and cause capital consumption—all effects signifying a drastic fall in general standards of living. Furthermore, only a free society is casteless, and therefore only freedom will permit mobility of income according to productivity. [Socialism], on the other hand, is likely to freeze the economy into a mold of (non-productive) inequality.”

Professor Rothbard goes even further by pointing out that such a goal, is not only inefficient and ineffective, but is also unethical and fake – or, in other words, systems like HFE are really Horizontal Fiscal Ersatzism11: “In all discussions of equality, it is considered self-evident that equality is a very worthy goal. But this is by no means self-evident. For the very goal of equality itself is open to serious challenge. If [humanity] is diverse and individuated, then how can anyone propose equality as an ideal? If each individual [and aggregation thereof like a state or territory] is unique, how else can he/she [or they] be made “equal” to others than by destroying most of what is human in him/her [or them] and reducing human society to the mindless uniformity of the ant heap? The fact must be faced that equality cannot be achieved because it is a conceptually impossible goal for [humanity], by virtue of his/her necessary dispersion in location and diversity among individuals. If a goal is pointless, then any attempt to attain it is similarly pointless.”



Private lives and public interest

When litigation looms large on the horizon, a party anticipating being caught up in court proceedings can be concerned to ensure that their personal affairs or other sensitive information will not be unnecessarily exposed. In that context, the need for privacy often goes well beyond a wish to avoid the intrusions of inquisitive third parties; in some circumstances, there can be very real risks to respondents or defendants if their personal details become widely known, and parties may be well within their rights in seeking to preserve confidentiality in the long term. The need for protection from the courts against the consequences of disclosure of information has recently been dealt with by the Grand Court of the Cayman Islands in two different contexts.

Confidentiality in trusts litigation

In the case known as In the Matter of a Settlement dated 16 December 2009 a trustee of a Cayman Islands trust had sought the Grand Court’s blessing for certain decisions and proposed actions by the trustee. However, in advance of the main action being formally issued, the trustee made an ex parte application pursuant to which it sought confidentiality orders on three main grounds:

That such orders were necessary to protect actual and contingent beneficiaries of the trust from the personal safety risks of being publicly linked to the substantial wealth associated with the trust;

That, as certain beneficiaries had been revocably excluded as beneficiaries of the trust, there was no useful purpose in apprising them of a mere expectancy that they might benefit under the trust at some point in the future;

In any event, the adult beneficiaries did not wish the minor contingent beneficiaries to become aware of their family’s link to substantial wealth for fear that it would adversely affect their personal development.

Justice Ian Kawaley agreed that confidentiality orders were appropriate in the circumstances of that particular case. While the concerns raised by the trustee were “generic concerns often expressed in similar applications” made in Cayman, the judge nonetheless considered that it was because of their familiarity to the Grand Court that those concerns were both cogent and credible. The judge also acknowledged that it is increasingly common for persons who have accumulated significant wealth to wish their children to live, as far as possible, “ordinary” lives and to be left unaware of the scale of wealth to which family members potentially have access. Security issues were also taken into consideration, with the judge noting that substantial wealth can give rise to serious personal safety risks.

In reaching a final decision in respect of the trustee’s ex parte application, the judge was required to carefully balance the principle of open justice and the rights of privacy – both of which are constitutionally protected under Cayman Islands law. Section 7 of the Cayman Islands Constitution records, among other things, that everyone has the right to a fair and public hearing in their determination of his or her legal rights and obligations, and that all proceedings instituted for the determination of any civil right or obligation shall be held in public. However, it is open to the court to hold private hearings in circumstances where publicity would prejudice the interests of justice, or where the welfare of minors or the protection of the private lives of persons concerned in the proceedings is warranted. The “public hearing” requirement is therefore not an absolute one and subject to these exceptions.

The court acknowledged that private hearings may take place in the circumstances anticipated by the constitution. The court noted that, in the trusts law context, the need for transparency will be strongest where persons linked to the trust are subject to tax or regulatory proceedings, or the sources and “concealment” of their wealth are matters which are already the subject of media scrutiny. However, in this case, the judge was satisfied that there was no public interest in open justice which outweighed the countervailing interests of protecting the welfare of minor beneficiaries, protecting the private lives of adult beneficiaries, and generally protecting the trustee’s ability to “peaceably holding and administer the trust assets.” On this occasion, the private lives of the beneficiaries of the trust were protected from the prying eyes of the public.

Confidential information and Norwich Pharmacal orders

Confidentiality of information is an issue not just limited to private individuals: corporate entities may also be asked to produce information in the course of more general litigation. There are a number of procedures in the Cayman Islands which enable a party to obtain disclosure of documents and information from the other party in advance of a trial and obtaining “Norwich Pharmacal” orders is just one of these.

As a general rule of civil procedure, an action for discovery or disclosure will not lie against a person against whom there is no reasonable cause of action, or who is a mere witness.

However, this rule does not apply where an action could not be commenced against the wrongdoer without discovery of the information sought, or where the person against whom discovery is sought has become involved (although innocently) in the wrongdoing. A Norwich Pharmacal order, named after the judgment in Norwich Pharmacal Co. v Customs and Excise Commissioners in which such orders were first made, allows for pre-action discovery against a non-party. Such orders have been made relatively regularly by the Grand Court but require careful consideration against local conditions and legislation.

In the notable recent decision in Discover Investment Company v Vietnam Holding Asset Management Limited & Anr (Discover) the court explored the relationship between the regime under the Confidential Information Disclosure Law 2016 (CIDL) and the jurisdiction to grant orders for disclosure pursuant to the Norwich Pharmacal line of cases. In Discover, the applicant sought to use the Norwich Pharmacal regime as a method of seeking information in relation to suspected payments by the respondents of monies that constituted undisclosed/secret profits by a former director of the respondent. The applicant was intending to deploy the information it obtained in potential claims for breach of fiduciary duty against that former director. However, the respondents were subject to contractual duties of confidentiality in respect of the information (owed to an entity that had received the payments in question) which pointed towards the possible need for a preliminary direction under section 4 of CIDL in order to authorize disclosure.

If granted, a section 4 direction can insulate a disclosing party from an action for breach of confidence from the principal to whom the duty of confidence is owed, in the absence of consent by the principal. The downside is that such a direction requires a separate court application to be made, on notice to the attorney general of the Cayman Islands, who is entitled to appear as amicus curiae in place of the party whose confidential information is in issue. In Discover, the court found that no section 4 direction was in fact necessary in the circumstances. It based its conclusions upon:
section 3(1)(j) of CIDL, which provides a defense to an action for breach of confidence where the information is disclosed “in accordance with, or pursuant to, a right or duty created by any other Law or Regulation“; and
section 3(2) of CIDL, which provides a defense to a person who discloses confidential information “as long as the person acted in good faith and in the reasonable belief that the information was substantially true and disclosed evidence of wrongdoing.”

The information sought in Discover concerned details of the very payments that constituted the secret/undisclosed profits by the former director, so the section 3(2) CIDL defense was directly applicable. It was also relevant that the parties who would need to seek the section 4 direction were already before the court.

As to future cases, it will be interesting to see how broadly the court casts the availability of the section 3(1)(j) CIDL defense. The court recognized in the Discover judgment that section 11(1) of the Grand Court Law 2015, which is the statutory footing for the court’s jurisdiction to grant Norwich Pharmacal orders (and indeed interlocutory relief generally), constituted another “law or regulation” for the purposes of the availability of the statutory defense. If the court takes an expansive view, it may mean that section 4 directions are unnecessary in any scenario where the court has made a disclosure order using its powers under section 11(1) of the Grand Court Law. This would have distinct practical advantages where the parties who would otherwise have to make a separate court application for a section 4 CIDL direction are already before the court.


These recent judgments make it clear that the Grand Court has an important role to play in guiding individuals and corporate entities as to their rights and duties under Cayman law, as well as the extent of the protections open to them, whether as innocent parties caught up in ongoing litigation or active litigants seeking the Grand Court’s assistance to proceed without risk. Further judgments contributing to the evolution of this guidance, in both contexts, are expected throughout 2019.

The Federal Reserve is between a rock and a hard place

The Fed seems to be in a desperate race toward normalization before a downturn in the economy arrives so that it has some tools to help fight the next recession.

As the financial crisis started to become apparent to the policy makers on the Federal Open Market Committee (FOMC) at the Federal Reserve System (Fed) in late 2007, they started implementing fairly dramatic and extraordinary policy options.

The trouble is they were too drastic and they lasted far too long. Now, more than a decade later, the economy is in very good shape and based on its actions the Fed’s number one priority appears to be to achieve “monetary policy normalization.”

To the Fed, this means getting the federal funds (fed funds) rate up to a 3.5 percent to 4.0 percent range and the Fed’s balance sheet assets down to a level closer to where they were prior to the financial crisis.

The Fed seems to be in a desperate race toward normalization before a downturn in the economy arrives so that it has some tools to help fight the next recession. The Fed’s conundrum is whether it can achieve normalization without causing the economic downturn for which it is trying to prepare. In other words, the Fed is between a rock and a hard place.

How the Fed got there

As the bursting of the housing bubble in 2007 and its spillover effects on the U. S. economy and financial system became obvious, the Fed’s FMOC implemented a number of policy responses. The two most prominent actions were: (1) reducing interest rates and (2) purchasing securities on the open market.

Starting in September 2007 and ending in December 2008, the fed funds target rate was reduced from about 5.25 percent to a range between 0 percent and 0.25 percent. This near zero interest rate remained in effect until December 2015, a full seven years.

Prior to the start of the Great Recession, the Fed’s balance sheet had assets of about $900 billion consisting mostly of U. S. Treasury securities and it had liabilities and capital of about $900 billion consisting mostly of currency in circulation, reserve balances, and the Fed’s capital account.

Between 2009 and 2014, the Fed undertook three rounds of so-called “quantitative easing” (QE), buying Treasury securities, agency debt and agency mortgage-backed securities (MBS). These securities now comprise the majority of the assets on the Fed’s balance sheet.

By 2014, the Fed’s balance sheet ballooned to a peak of $4.5 trillion, including nearly $1.8 trillion of MBS, which are debt instruments primarily issued by three government, housing- finance related agencies: the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Government National Mortgage Association (Ginnie Mae).

The Fed purchased these debt securities (bonds) from financial institutions, primarily commercial banks. To a great extent, they were bought to support their prices at a time when their values were unknown and the commercial banks and other financial institutions were anxious to get them off their books. In effect, the Fed created its own TARP (Troubled Asset Relief Program) primarily to help bailout commercial banks at taxpayers’ expense.

When the Fed buys securities from a commercial bank, it debits an asset account such as Treasury securities or mortgage-backed securities on the asset side of its balance sheet and credits the selling bank’s reserve balance account on the liability side of the Fed’s balance sheet. These additions to the Fed’s balance sheet liability account, reserve balances are simply created out of thin air; it is new money (credit) created by the Fed to purchase the securities. Today, the account, reserve balances represents about 45 percent of the Fed’s liabilities consisting of required reserves and mostly excess reserves. Other major liability accounts are: currency in circulation (Federal Reserve notes), U. S. Treasury accounts, foreign official accounts, non-bank deposits, and the Fed’s capital account. In 2008, the Fed began paying interest on bank excess reserves (IOER) which now consist of more than 90 percent of all reserve balances.

One of the effects of IOER is that the banks sat on the funds (interest paying reserve deposit accounts at the Fed) instead of making new loans, creating deposits, and thereby stimulating economic growth. The Fed, with IOER, in effect, paid the banks for not lending and QE did not result in much economic growth or accelerated inflation as many people had anticipated.

After the Great Recession ended, inflation remained low, unemployment remained high, and gross domestic product (GDP) grew at a very slow rate.

Because of price distortions caused by the Fed’s policies, many markets in the economy experienced significant disruptions. For example, in 2011, the price of an ounce of gold spiked to nearly $1,900 from less than $900 an ounce in 2008. In 2012, investors piled into U. S. Treasuries, pushing down the yield on the 10-year note to a 200-year low. In 2013, the Dow Jones Industrial Average ran up 24 percent while the demand for bonds reversed course and interest rates jumped 75 percent. During 2014 and 2015, the value of the U. S. dollar rose 25 percent. In essence, the Fed lowered interest rates to zero for seven years and printed $3.5 trillion of new money with the objective of stimulating the economy, only to cause major disruptions to markets and produce the weakest economic recovery in history.

In the fall of 2014, the Fed began reversing the policy actions it started in 2007. During the month of October 2014, the Fed ended its program of quantitative easing; it stopped its massive program of open market securities purchases.

Its asset portfolio then remained essentially unchanged for the next three years. Near the end of 2017, the Fed started reducing its portfolio $10 billion per month by allowing maturing securities to runoff without replacing them. Last year it reduced its bond portfolio by $20 billion per month in the first quarter of the year, $30 billion per month in the second quarter, $40 billion each month in the third quarter, and $50 billion monthly in the forth quarter. At the rate of $50 billion a month, the Fed’s balance sheet is shrinking at a rate of $600 billion per year.

Starting in December 2015, the Fed began implementing a plan to raise interest rates 0.25 percent every March, June, September, and December. On Dec. 19 of last year, the Fed raised the fed funds rate for the ninth time to a target range of 2.25 percent to 2.50 percent.

That afternoon Fed Chairman, Jay Powell held a press conference. While the December interest rate hike was widely anticipated and built into most market prices, Powell’s remarks had a major disruptive effect on financial markets. First, he stated that it is likely that there will be two more rate hikes next year and then responding to a question regarding balance sheet normalization, Powell said that the Fed’s balance sheet runoff is on autopilot and would continue at the $50 billion per month rate.

Those remarks seemed to have a negative impact on both the equity and credit markets. That afternoon, the S&P 500 index dropped by 1.51 percent after being up more than 1 percent earlier in the day. The 10-year Treasury note yield fell to 2.7673 percent and the 2-year fell to 2.6417 percent.

A little over two weeks later, during a panel discussion at the American Economic Association’s annual meeting in Atlanta on Jan. 4 of this year, the Fed chairman seemed to reverse course and had a new message for the markets. Saying the U. S. economy has “good momentum,” he added, “With the subdued inflation reading we’ve seen coming in, we will be patient as we watch to see how the economy evolves.” He said the Fed is also aware of market concerns over the reduction of its balance sheet. Despite proclaiming the Fed’s new market sensitivity, surprisingly, he said he does not think the portfolio runoff is an important part of the story of the recent market decline.

What the Fed should do

It is time for the Fed to heed an old Wall Street saying, “There’s a time to buy; there’s a time to sell; and there’s a time to go fishing.” In other words, the Fed should do nothing unless there is some significant change to the country’s economic status.

In early January, the president of the Dallas Fed, Robert Kaplan said that because of slowing global growth, weakness in rate-sensitive industries, and tightening financial conditions that have included a sharp stock market drop, the Fed should stop raising rates until it gets a clearer picture of where the economy is headed.

Other reasons for keeping rates at current levels include the fact that by most measures, there are excessive debt loads carried by the public, business, and household sectors, in other words, just about the entire economy is over-leveraged.

These high debt levels in addition to the fact that real interest rates were zero for such an extended period of time, means that the economy has a higher than normal sensitivity and vulnerability to increases in the rate of interest.

Interest rate increases also exacerbate the burden of servicing these high debt levels. People at home and in various institutions have grown accustomed to zero real interest rates and it will take some time for them to adjust their attitudes, thinking and behavior. All of these are conditions to which the FMOC seems to have been oblivious.

The Fed also should quit quantitative tightening (QT); stop shrinking the size of its balance sheet. There are few good reasons for continuing the market disrupting actions of further QT. Keeping the Fed’s balance sheet assets around $4 trillion would not constrain the Fed from additional asset purchases if the FOMC though they were needed. In a Brookings Institution article published on Jan. 26, 2017, entitled, “Shrinking the Fed’s balance sheet,” former Fed Chairman, Ben Bernake stated, “that there are reasonable arguments for keeping the Fed’s balance sheet large indefinitely, including improving the transmission of monetary policy to money markets, increasing the supply of safe short-term assets available to market participants, and improving the central bank’s ability to provide liquidity during a crisis.” With large amounts of reserves, the banking system is in a lot safer position than if bank reserve balances were equal only to those bank reserve deposits which are required.

I have read where many economists have expressed the opinion that the Fed has nearly total control over the size of its balance sheet; this is not the case. Most analysts concentrate all of their attention on the asset side of the Fed’s balance sheet while ignoring its liability side. Currently, there are about $700 billion in Fed liabilities associated with non-banks; these include deposits held by the U. S. Treasury, foreign central banks, international agencies, and non-bank financial institutions in the U. S. The Fed provides banking services on demand to these institutions. In addition, there is the Fed’s capital account and approximately $1.7 trillion of currency in circulation.

Currency in circulation, which consists mostly of $100 denominated Federal Reserve notes is not a bad kind of liability to have since these debt instruments which serve as legal tender require no interest payments. In the year 2000 this liability account stood at about $600 billion. At the time of the financial crisis it was around $800 billion. Today, this liability account is approximately $1.7 trillion.

Given its growth, in another five to seven years, currency in circulation could be approaching $2.5 trillion. The consistent growth of the majority of the Fed’s liabilities is largely outside the control of the Fed and it will need to offset these additional liabilities by increasing the Fed’s securities portfolio. Over time, the Fed’s ability to shrink its balance sheet may be surprisingly short-lived.

As I wrote earlier, in recent years the Fed’s number one priority appears to be to achieve monetary policy normalization. It is somewhat understandable that the Fed wishes to be prepared for the next recession or financial crisis. However, its statutory objectives do not include normalization; they are maximum employment and price stability. Recent economic data demonstrate that the U. S. economy is doing quite well on both of these measures. So, for a while at least, the Fed should try to find a confortable spot somewhere between a rock and a hard place and start casting a fishing line.

Dennis W. Richardson is a retired investment banker who has held high-level positions in academia, government, banking, and industry. He is the author of “Electric Money” a book published by MIT Press and holds a Ph.D. in finance from the University of Texas at Austin.

A review of the world’s offshore financial centers: Cyprus

Cyprus. Marina in foreground with city behind.

Cyprus, officially the Republic of Cyprus, is an island country in the northeast corner of the Eastern Mediterranean, strategically located at the crossroads of three continents: Europe, Asia and Africa.

Cyprus is the third largest and third most populous island in the Mediterranean.

Cyprus has been inhabited since the Prehistoric period dating back to the 10th millennium BC.

Cyprus was settled by Mycenaean Greeks in the 2nd millennium BC. As a strategic location between Europe, Africa and the Middle East, it was subsequently occupied by several major powers, including the Assyrians, Egyptians, Persians, Romans, the Eastern Roman Empire, Arab caliphates, the French Lusignan dynasty, the Venetians, the Ottoman Turks and the British, until finally achieving independence from the UK in 1960.

In large part due to its favorable tax climate and low tax rates, since the 1970s Cyprus has developed into a premier offshore financial center, offering the incorporation of offshore and onshore companies and trusts and offshore banking services among others.

The official languages are Greek and Turkish, but being a former British colony and a common law country, English is widely used in business and government, signs are typically bilingual, many Cypriots attended higher education in the U.K., and nearly everybody speaks fluent English.

Government and legal system

Facts about Cyprus: Official name Republic of Cyprus Capital and largest city Nicosia Official languages Greek, Turkish Business languages Greek, English Government Unitary presidential constitutional republic Independence from the UK 1960 Currency Euro (EUR) Joined the European Union 2004 Joined the Euro Zone 2008 Population 1,170,125 Area 9,251km2 Time Zone UTC+2 (EET) GDP (PPP) 2016 $29.666 billion GDP (PPP) 2016 per capita $34,970 (35th) GDP (nominal) 2016 $19.810 billion GDP (nominal) 2016 per capita $23,352 (33rd) Human Development Index (2017) 0.869, very high (32nd) Leading industries Financial services, Tourism, Real estate, Shipping Climate Mediterranean climate with warm, dry summers and cool winters, 340 days of sunshineCyprus is a unitary presidential republic with a written constitution which safeguards the rule of law, political stability and human and property rights. The Republic of Cyprus is a member of the Eurozone and a member state of the European Union. Before 1960, Cyprus was part of the British Empire and adopted the U.K.’s legal and judicial system. As a result, the Cyprus legal system is still modeled after English common law, and also its company law is based on English company law. Cyprus’ legislation, including employment law, is fully aligned and compliant with European Union legislation. European Union directives are fully implemented into local legislation and European Union regulations have direct effect and application in Cyprus.

Taxes in Cyprus

Cyprus hardly suffers from a tax haven stigma because of its very diverse and flourishing economy, its full membership of the EU and Eurozone, because it does not appear on any tax haven black lists, and it has many of the same taxes that high-tax countries levy, such as a personal and corporate income tax, a value added tax, and a capital gains tax. However, at the same time, Cyprus has no inheritance taxes or gift taxes, a large number of very generous exemptions, very low tax rates, especially by EU standards, and a very favorable holding regime, which helped Cyprus become one of the premier financial centers of Europe.

When Cyprus joined the EU in 2004, it immediately became a top EU holding company jurisdiction because of its favorable tax climate and holding regime, which now could be combined with benefiting from the EU’s treaty freedoms and the favorable decisions in tax matters by the European Court of Justice.

Corporate income tax

A company is tax resident for the corporate income tax in Cyprus if it is managed and controlled from Cyprus. A company which is tax resident in Cyprus is taxed on income accruing or arising from sources both within and outside of Cyprus. A company which is not tax resident in Cyprus is taxed only on income accruing or arising from sources within Cyprus. The tax rate is 12.5 percent. Many exemptions apply. Most dividend and interest income, foreign exchange gains and gains from the disposal of securities are exempt from corporate income tax, as are profits from a permanent establishment maintained outside of Cyprus.

IP box regime Cyprus

The Income Tax Law in Cyprus provides for an intellectual property (IP) rights box regime. Qualifying taxpayers are eligible to claim a tax deduction equaling 80 percent of qualifying profits resulting from the business use of the qualifying assets, resulting in an effective tax rate of 2.5 percent.

Introduction of notional interest deduction (NID) on equity

Corporate entities are entitled to NID on equity as of Jan. 1, 2015. The NID equals the product of the reference interest rate and the new equity held and used by a company in the carrying on of its business activities.

Capital gains tax

Cyprus has a capital gains tax of 20 percent. It is only levied on transactions directly or indirectly involving immovable property in Cyprus.

Value added tax

Cyprus has a value added tax with a regular rate of 19 percent and reduced rates of 5 percent and 9 percent for transportation, tourism, catering, food, pharmaceuticals, books and similar products and services.

A zero percent rate applies to exported goods and services. In spite of EU harmonization, Cyprus has numerous indirect tax and VAT incentives to offer to current and prospective investors ranging from simplified procedures to favorable rates to user-friendly policy practice.

Personal income tax

In general an individual who spends more than 183 days in Cyprus is considered a tax resident. An individual who is not tax resident in Cyprus, is taxed only on income accruing or arising from sources within Cyprus.

The income tax rate is progressive from 0 percent on the first EUR19,500 to 35 percent on all income over EUR60,000. Many types of income are exempt, such as dividend and interest income, and most foreign exchange gains and gains arising from the disposal of securities.

Special defense contribution (SDC)

All Cyprus tax resident and domiciled individuals are subject to the special defense contribution (SDC) on the following types of income. Dividend income: 17 percent; interest income: 30 percent; interest from saving certificates and development stock issued by Cypriot government: 3 percent; and rental income (gross): 3 percent. An exemption is granted for individuals not domiciled in Cyprus. Non-resident individuals are not subject to the SDC.


The Government has recently introduced the “non-domicile” (non-dom) rules which state that a Cyprus tax resident individual who is not domiciled in Cyprus will effectively not be subject to SDC in Cyprus on any interest, rents or dividends (whether actual or deemed) regardless of whether such income is derived from sources within Cyprus and regardless of whether such income is remitted to a bank account or economically used in Cyprus.

Exemptions/deductions from PIT

The most lucrative incentive that Cyprus offers to individuals who have not been Cyprus tax residents before the commencement of their employment in the island is the exemption from PIT of 50 percent of their remuneration from any employment exercised in Cyprus which commenced as of Jan. 1, 2015.

This exemption is available for ten years and relates to remuneration in excess of EUR100,000 per annum. In cases where the remuneration is below EUR100,000, 20 percent of the remuneration or EUR8,550 (whichever is lower) can be claimed as a deduction for a period of five years starting from Jan. 1 following the year of commencement of the employment (provided the employment started during or after 2012). This exemption applies up to year 2020. Conditions apply.

Social insurance and payroll taxes

Social insurance and other contributions are payable on a gross income up to EUR55,000. The rates are 7.8 percent for both employer and employee. Additional contributions up to 3.7 percent of the income are paid by the employer. Similar taxes are paid by self-employed individuals.

Immovable property tax

As of 2017, the immovable property tax has been abolished.

Wealth tax

Cyprus has no wealth tax.

Inheritance and gift taxes

Cyprus has no inheritance or gift taxes.

Withholding taxes

Cyprus has no withholding tax on dividends or interest, but does have a withholding tax on royalties paid to non-residents for the use of rights in Cyprus. This is subject to a withholding tax of 5 percent on film and television royalties, and 10 percent on all other royalties, although a tax treaty may apply and reduce the amount. Royalties paid to a non-resident for the use of rights outside Cyprus are not subject to any withholding tax.

Tax treaty network

Cyprus has conducted agreements for the avoidance of double taxation with 45 countries across the world. These tax treaties serve to protect taxpayers from double taxation by restricting the right to tax of the contracting states. Especially the tax treaties with countries in Eastern Europe (including Russia and Ukraine) are very attractive, which is why foreign investments into these countries are very often done via a Cyprus Holding Company.

Holding regime Cyprus

Cyprus is a member of the European Union and a member of the ‘whitelist’ of the OECD. Its tax system is OECD-approved and an EU compliant tax system. As an EU member it has implemented the EU Parent-Subsidiary Directive and is a part of the internal market. As such Cyprus is a jurisdiction that is an attractive financial center for investors to locate their holding companies in order to participate in subsidiaries in the EU and other countries with which tax treaties are in force.

Cyprus has one of the lowest corporate tax rates in the EU. It is possible to obtain tax rulings in advance from the tax authorities, which provides flexibility and minimization of tax risk. Tax treaties with 45 countries are in force. There is absolute freedom of movement of foreign currency which allows the maintenance of a bank account in any foreign currency. There is no tax on gains from sale of securities (i.e. shares, bonds, debentures etc.) There is no tax on dividends received as a shareholder for other subsidiary companies (Note that for dividends from abroad certain minor conditions apply). Dividends, interest or royalties (except for intellectual property utilized in Cyprus) paid by a Cyprus company to non-residents are not subject to any withholding tax.

There are no taxes on entry, reorganizations or exits. Company reorganization rules ensure tax neutrality for group restructuring transactions. There is no controlled foreign company (CFC) legislation. There are no detailed transfer pricing rules; only the arm’s length principle applies. Neither are thin capitalization rules or debt/equity ratios imposed. Foreign source income is generally tax exempt and a unilateral credit relief is given for foreign taxes. These combined benefits have made Cyprus’ tax climate more attractive in general than other European holding company jurisdictions.

Cyprus Flag

Conducting business in Cyprus

The attractive tax system, along with a low burden of rules and regulations, makes Cyprus naturally attractive for entrepreneurs who want to minimize their tax and regulatory burden. By establishing a company in Cyprus, entrepreneurs can protect their assets against confiscatory taxes and other dangers. Cyprus has no exchange controls in place. This makes it easy for individuals and corporations to transfer funds in and out of the country. Import and export of capital, profits and wages are entirely free. A short summary of what Cyprus has to offer:

  • EU member, thus benefiting from EU’s treaty freedoms and favorable ECJ decisions in tax matters
  • Highly educated, qualified and multilingual personnel
  • Extensive range of excellent legal and accounting services
  • Cost-effective setting-up and on-going operational services
  • Favorable EU and OECD-approved tax regime
  • Access to an extensive network of double tax treaties allowing for tax efficient structuring of investments
  • Collective investments can be listed on the Cyprus Stock Exchange and other recognized EU stock exchanges
  • Cyprus-based funds and asset managers benefit from low tax burdens levied on Cyprus-based corporations
  • Incentives and tax benefits for high-earning managers and high-net-worth individuals
    Modern and efficient legal, accounting and banking services based on English practices
    Sophisticated road, air and sea transport solutions and services
  • Two multi-purpose deep sea ports are located in Limassol and Larnaca

Living in Cyprus

The island of Cyprus enjoys a Mediterranean climate with 340 days of sunshine and is a prosperous, safe and pleasant place to live. High quality health care and education, including international schools and colleges, are widely available. You will feel welcomed no matter what part of the world you are from. Over the past years Cyprus has become a home to many expatriates and it offers a friendly and vibrant environment. In Cyprus you will enjoy recreational centers, restaurants, bars, theatres, exhibitions and museums, sport events and festivals. Beautiful beaches and picturesque landscapes offer yet another opportunity to relax and enjoy your stay. The beautiful Troodos Mountains offer skiing in winter. All this contributed to Cyprus having become a major tourist destination in the Mediterranean.

Cyprus company law

Incorporation of a private Cypriot company is a relatively easy process which typically takes up to two weeks. Alternatively, shelf companies can be purchased easily. The ease of setting up a company in combination with one of the lowest corporation tax rates in the EU, an extensive double tax treaties network and the availability of special taxation regimes makes the operation of a business through a company a very popular option.

Cyprus investment funds

Since 2014, Cyprus has reformed its legislation governing investment funds and fund managers. Cyprus now has efficient and up-to-date regulation, fully harmonized with related EU directives.

Cyprus as an investment fund jurisdiction has a number of advantages:

  • Choice between fully regulated investment fund/fund manager regime and regime with milder regulation
  • Wide range of investment fund products offered within the new regulation
  • No restrictions on types of investments
  • EU member state with easy access to European investors through EU passporting
  • Mature business center with highly qualified professionals and sophisticated infrastructure
  • Most types of income earned by investment funds are not subject to tax in Cyprus
  • Low tax rates levied on Cyprus-based corporations; tax incentives and benefits for high-earning managers and high net worth individuals
  • Access to extensive network of double tax treaties
  • Cost-effective setting-up and ongoing operational services
  • Strategic geographical location between Europe, Middle East, Asia and Africa

The recent changes in the legislation and regulations have already proven to attract fund managers to use Cyprus as the jurisdiction for investment funds and the managers. The assets under management have grown to EUR3 billion. There are 17 licensed and 22 registered asset managers, over 80 licensed investment funds, and many more managers and funds are underway of registration with the regulator.


Shipping has been one of the driving forces of the Cyprus economy, with the sector contributing around EUR1 billion to the island’s GDP per annum. In recent years, Cyprus has become one of the leading ship management centers and currently hosts the 10th largest merchant fleet in the world and third largest in Europe.

The country is most certainly at the forefront of world shipping and, as such, offers sound maritime infrastructure, a business friendly tax regime, competitive ship registration and annual tonnage tax rates. At a time when the shipping industry is experiencing a considerably large supply of tonnage and uncertainties from sovereign debt, Cyprus offers competitive advantages to shipping sector participants and continues to play a prominent role as a leader in shipping and as a ship management hub.

  • Key benefits of Cyprus’ shipping:
  • 10th largest fleet worldwide
  • 1st third party ship management center in the whole EU
  • 25 percent of the whole EU fleet
  • Liberal Foreign Direct Investment Regime allowing up to 100% foreign participation in most sectors of the economy
  • No exchange control and freedom of movement of foreign currency
  • Favorable tonnage tax scheme approved by the EU
  • Bilateral agreements of cooperation in merchant shipping with 23 countries including major labor supplying countries

Yacht and aircraft leasing scheme

In an effort to encourage the use of Cyprus as a host jurisdiction for yachts and aircrafts and to make Cyprus an even more attractive destination for yacht and private aircraft owners, Cyprus has introduced the “yacht leasing scheme” and the “aircraft leasing scheme.” The aim of the yacht and aircraft leasing schemes is to assist yacht and aircraft owners in deferring payment of VAT and paying a reduced VAT rate on their yachts and aircrafts calculated as a percentage of the time that the asset is deemed to sail/fly Marshall in EU waters/airspace.

Cyprus citizenship for investors

Cyprus citizenship may be granted to foreign investors and entrepreneurs through naturalization by exception under certain criteria and conditions. The process is an expedited procedure (around 6 months) and citizenship is also granted to the investor’s spouse, under age children and adult financially dependent children up to 28 years old. The investor and his/her family obtain a Cyprus Passport with full rights of an EU citizen (i.e. free travel, residence and investment in any EU country). The scheme requires, inter alia, the following from the applicant:

  • Clean criminal record
  • Ownership of a permanent private residence in Cyprus with a purchase price of at least EUR500,000 (plus VAT)
  • Investment of at least EUR2m (plus VAT where applicable) in one of the qualifying categories.

Permanent residence

Non-Cypriot investors, who purchase property in Cyprus of at least €300.000 (plus VAT where applicable) and have secured annual income are entitled to apply for Permanent Residence. The relevant Permit grants investors and their families visa free travel to Cyprus and the right of residence granted for life.

Politicians everywhere always create tax laws that are extremely complicated and riddled with conditions, exceptions, exceptions to exceptions, etc. Cyprus is not as bad as most countries, but still suffers from the same problem. This article only provides a very basic description of Cyprus tax laws. Always consult a qualified tax advisor before implementing any strategy discussed herein.

What are the policies President Bolsonaro intends for Brazil?

Brazilian street packed with people
The main concern Brazilians have right now is whether President Bolsonaro will be able to deliver what he has promised.

President BolsonaroOn Oct. 28., 2019, Jair M. Bolsonaro won the runoff of the 2018 Brazilian presidential elections and became the 38th president of the country. He received 55 percent of the votes against the 45 percent of Worker’s Party (PT) candidate Fernando Haddad.

Most of the coverage coming from international media has been simplistic and is almost only repeating clichés such as calling him the “Brazilian Trump” or comparing him to other right-wing candidates from other parts of the world. Although there are certainly some similarities to other candidates, these comparisons must be done with prudence.

Just like Trump, Bolsonaro is also perceived as someone that does not behave in the same way or says the same rehearsed lines like every other politician. He is perceived as an outsider, as he is breaking the standard polarization of the Brazilian elections between the Worker’s Party and the Social Democratic Party. On the other hand, Bolsonaro has been a member of Congress representing the state of Rio de Janeiro for almost 30 years. He is not a newcomer running for his first political experience, as Trump was.

Mr. Bolsonaro gained popularity in the middle of the most critical economic crisis Brazil has ever had. The GDP decreased 3 percent in 2015 and 2016, a worse result than in 1930 and 1931, after the crash of 1929. This economic crisis was caused by the policies of former President Dilma Rousseff, who supported interventionist policies both on the fiscal and the monetary side.

Quoted text: Most of the coverage coming from international media has been simplistic, calling him the ‘Brazilian Trump.’After Rousseff’s election in 2010, she started to increase government spending to stimulate the economy, lower taxes only for some well-organized industrial sectors, and use government-owned banks to increase cheap credit for mostly large companies. She pushed for crony capitalism in every policy, forcing Brazilian investors to spend more time in Brasilia and lobby for privileges than invest in improving their competitiveness. That made many large companies dependent on government in order to keep their profits. When the fiscal crisis arose, compelling the federal government to step back from its aggressive fiscal and monetary policies, unemployment started to rise and the economy crashed. Make no mistake: interventionism is the cause of Brazilian economic demise.

Being seen as the Worker’s Party main antagonist draws the attention of the Brazilian people. If you have been following or at least read a piece or two from mainstream sources, you might be wondering what are Bolsonaro’s policy proposals and how can they affect the Brazilian economy? Beyond the well-known quotes, the Brazilian electorate see him as a clean politician (unlike the others) and someone that will be tough on crime (unlike the others). At the same time, he appointed Paulo Guedes, who holds a PhD in Economics from the University of Chicago, as economy minister. He picked Mr. Guedes because Chicago classical liberalism is associated with more economic freedom, the opposite direction from Dilma Rousseff’s administration. Bolsonaro and Guedes already talked about some of the reforms they will put forward as soon as they get to office. Let us analyze the most relevant ones.

1) Pension reform
Brazil has one of the most generous pension systems in the world. Some workers, especially government employees, are able to retire at the age of 50 (sometimes even younger), while life expectancy is currently at 75, not far from the 78 in the United States. This made specialists in Brazil call its pension system a time bomb about to explode.

With this in mind, Michel Temer, the vice president who ascended to the presidency after the impeachment of Dilma Rousseff in 2016, tried to push Congress into passing a pension reform. Among its policy changes, the most important is the requirement of a minimum age of 65 to retire. This reform is so urgent that many believe Brazil, in the long term, will not be able to comply with the spending cap amendment if it does not reform its pension system.

In the last two decades, Brazil has become one of the most attractive countries in terms of investment opportunities but its fiscal policy make business and investors fear for the country’s economic stability. The pension reform is key to make local and foreign investors trust the country for long term investments.

2) Tax Reform
Brazil, similarly to the U.S., is a Federal Republic. That means states have a certain autonomy, including the right to set tax rates. For instance, many business and consumers end up paying the state sales tax, a local sales tax (municipality) and sometimes a federal sales tax. All of them with different rates for different products. The same happens regarding other kinds of taxes and, although Brazil has a relatively low top income tax bracket – 15 percent for corporations and 27.5 percent for individuals – the number of other taxes and additional fees puts the Brazilian tax system among the most complex in the world. It is very time-consuming for a business that is located in different cities and in different states to plan their tax payments.

With that in mind, Paulo Guedes has already proposed a tax reform that would implement a flat income tax rate of 20 percent for both individuals and corporations and would eliminate many of the current existing taxes and substitute all of them for a new single tax. Although he can do it “easily” at the federal level, any constitutional reform that could change or limit state and local tax competences would be tough as it would require the support of governors and mayors, what could be difficult as neither business want to pay more in taxes nor state and local governments want to get less revenue. This can be a hard political and economic equation to solve.

3) Privatizations
The federal government owns many businesses in Brazil. From banks and the largest oil company, Petrobras, to smaller ones. In the past years, with the economic recession, many of them required government bailouts. Paulo Guedes has proposed to privatize everything, literally. On the other hand, Bolsonaro said that he favors privatization but wants to preserve government management over “strategic sectors.”

Temer pushed for the privatization of Eletrobras, the largest holding in the generation and distribution of electricity in the country. This will be a good test for the beginning of the Bolsonaro administration.

Another sector that could benefit from private investments, that the administration is well aware of, is infrastructure. Bolsonaro and Guedes want to make it easier for private companies to invest in roads and railways. One of the most audacious proposal, though, concerns the ports. Brazilian federal government owns dozens of ports all over the Brazilian Atlantic coast. With the fiscal pressure, it could not invest enough and many international traders say the ports are not good enough. This might be an opportunity to improve Brazilian infrastructure and attract foreign investments for the country.

Final thoughts

Bolsonaro became the political equivalent of what author Nassim Taleb calls “antifragile.” The more attacked he gets, the stronger he gets. He came to a point where he was able to benefit from the chaotic electoral environment. Now, he is the 38th president of Brazil, he must be evaluated on his policies. He has a good team of people that believe in freedom, democracy and the reforms Brazil needs to start growing again. The main concern Brazilians have right now is whether he will be able to deliver what he has promised.

Containing China

The Chinese character for China depicts a place between heaven and earth, at the center of the universe, and, for 5,000 years, China has viewed itself as the leading power on earth in terms of the quality of its civilization. The United States and other countries must keep this worldview in mind as they seek to contain China’s quest for global domination.

China continues to run a non-market-oriented economy. It provides heavy subsidies to its state-owned enterprises, dumps its exports unfairly, manipulates its currency, appropriates U.S. intellectual property, including patents, copyrights, and trademarks, and, most devastatingly, uses the Internet to seize an almost insurmountable advantage in the world of electronic commerce.

Most of the press coverage in the United States of U.S.-China trade issues has been about tariffs the United States has applied against China pursuant to Section 301 of the Trade Act of 1974, which allows the president to take all appropriate actions to counter the unfair acts, practices or policies of a foreign government. The containment of China, however, must be multi-dimensional, focused not only on tariffs, and played out by both Congress and the Executive Branch. Section 301 is but one tool in the U.S. arsenal of possible responses to China’s quest for global influence as a rising power. The problem with the Trump Administration’s Section 301 complaint against China is that, while its objective is correct – reducing our one-sided trade relationship with China – there is no well-defined overall policy of containment. Several steps have been taken thus far, but much more needs to be done. The purpose of this article is to outline an ongoing strategy of containment that the United States should use to counter China’s behavior in the marketplace.

II. Promotion of U.S. foreign investment: The BUILD Act

China’s Belt and Road Initiative has as its goal the creation of a new silk road for Chinese trade and investment throughout the developing world. Containing China requires a commitment to counter this initiative by supporting U.S. investment in infrastructure in emerging markets. A major step was taken in this direction on Oct. 5, 2018, when President Trump signed into law the Better Utilization of Investments Leading to Development (BUILD) Act of 2018, which creates a new foreign aid agency: the United States International Development Finance Corporation (IDFC). This largely overlooked legislation consolidates the Development Credit Agency (DCA) of the U.S. Agency for International Development with the Overseas Private Investment Corporation (OPIC) and triples the financing authority of OPIC from $22 billion annually to $60 billion. The IFDC has the authority to provide loans, loan guarantees and insurance to companies willing to do business in developing nations.

The drafters of the BUILD Act have made clear that its intent is to counter China’s drive towards global dominance by providing an alternative to “state-directed investments by authoritarian governments,” an obvious reference to China and its growing overseas aid. As Senator Bob Corker, the chairman of the Senate Foreign Relations Committee, stated, “We’re seeing what China is doing throughout Africa and South America …, and people are waking up and realizing we have to have involvement with the countries, not just for a return on investment, but to move them toward a market-based approach.”

The BUILD Act provides the resources for the United States to launch an ambitious program of infrastructure and low-carbon technology across the emerging world, which will be an effective counter to China’s Belt and Road Initiative.

III. Restrictions on inward foreign investment: CFIUS reforms

The second element of containment is to sharply limit, through U.S. government intervention, Chinese investment in the United States that is a threat to U.S. national security. It is appropriate to be skeptical of China’s investments in the United States in light of its predatory, mercantilist behavior, and recently documented Chinese-government-directed hacking of U.S. government agencies and private industry. The challenge here is to maintain the balance between the desire for commercial engagement with China and the need to check China’s quest for technological supremacy. As Assistant Attorney General John Demers has stated, “China wants the fruits of America’s brainpower to harvest the seeds of its planned economic dominance.”

Reviews of foreign investment in the United States are undertaken by the Committee on Foreign Investments in the United States (CFIUS), a federal inter-agency committee chaired by the Secretary of the Treasury. CFIUS national security reviews are usually conducted before foreign investment is undertaken, at the request of the foreign investor. However, the U.S. Government can undertake a CFIUS review after the foreign investment is made and unravel the transaction.

On Aug. 13, 2018, President Trump signed the Foreign U.S. Investment Risk Review Modernization Act (FIRRMA) to expand the U.S. government’s power to review investments from foreign countries. This legislation is a direct response to China’s efforts to obtain U.S. technology through mergers, acquisitions and takeovers.

There are three principal reforms under FIRRMA. First, the CFIUS inter-agency committee will now review proposed purchases of minority shareholding interests of U.S. companies. This is a significant shift in policy, which had permitted CFIUS reviews only of majority, or control, purchases. Second, the Committee’s jurisdiction now specifically includes real estate transactions located in an area adjacent to ports or near military installations or other sensitive U.S. government facilities. This was implicit in prior CFIUS legislation but has now been made explicit. Third, the bill expands CFIUS’s jurisdiction to include any investment by a foreign person in a U.S. business that (1) owns, operates, manufactures, supplies or services critical infrastructure; (2) produces, designs, tests, manufactures, fabricates or develops critical technologies; or (3) maintains or collects the sensitive personal data of U.S. citizens that may be exploited in a manner that threatens national security. Covered investments subject to CFIUS review include investments that afford a foreign person (1) access to material nonpublic technical information; (2) membership or observer rights on the board of directors of a U.S. business; or (3) involvement in decision-making regarding the sensitive personal data of U.S. citizens, critical technologies or critical infrastructure.

Investments in U.S. businesses by a foreign person through an investment fund as a limited partner are permissible, assuming the fund is managed by a general partner who is not a foreign person and the foreign person does not have the ability to control the fund or its investment decisions.

The net effect of FIRRMA is that investors from China, or any other foreign country, will have to thread a very narrow needle in order to invest in a critical U.S. technology or infrastructure. FIRRMA would appear to permit such investment only if the foreign investor is a minority, non-control, passive investor in a fund managed by a U.S. entity as the general partner.

IV. Tax reform

The third element of containment is international tax reform. America’s economic power is diminished and China’s enhanced when U.S. companies invest in China instead of the United States. The trend of outsourcing with foreign subsidiaries in China has been encouraged, however, by the U.S. tax policy of deferral of foreign source income that is earned by foreign subsidiaries.

This issue was addressed with the passage of the Tax Cuts and Jobs Act of 2017, U.S. federal tax legislation that entered into force on Jan. 1, 2018. By reducing the corporate rate of taxation from 35 percent to 21 percent, the new U.S. international tax policy will discourage direct foreign investment by U.S. enterprises. This move should significantly increase investment in the United States, and reduce imports from China, as currently an estimated 30 percent of all imports from China are imports from Chinese affiliate companies to U.S. parent companies.

V. Tighter export controls

The fourth element of containment should be the use of America’s export control program to limit the transfer of U.S. advanced technology to China.

High-end technology has emerged at the center of the U.S.-China trade war. The stated objective of China’s Made in China 2025 program is to make China a major competitor in advanced manufacturing. That program involves government subsidies, heavy investments in research and innovation, and targets for local manufacturing industries. Through these means, China plans to dominate leading-edge industries like electric cars, robotics and artificial intelligence.

President Trump has pushed China to drop these plans and to limit transfers of advanced U.S. technology that would support the Made in China 2025 program. On Nov. 22, 2018, the U.S. Department of Commerce called for public comments on whether a list of new technologies that would have national security implications, from artificial intelligence (AI) to microprocessors and robotics, should be subject to more stringent export control rules. The AI technologies that will be considered for tighter controls include technologies such as neural networks, deep learning, computer vision, natural language processing, and audio and video manipulation.

AI can have implications for military purposes and therefore should be carefully controlled through stringent U.S. export controls. Tighter export controls, however, would affect U.S. manufacturers as well as purchasers in China, since AI is a key element of many computer products made by U.S. tech firms, including smartphones, connected speakers and self-driving cars. Moreover, many high-tech products are used for both military and civilian purposes.

Unfortunately, both U.S. export controls and possible Chinese retaliatory tariffs could increase the costs for U.S. exporters of components and reduce competitiveness of U.S. manufacturers across a range of high-tech sectors. Therefore, export controls need to be very carefully calibrated in order to preserve the competitive position of U.S. exporters in the world marketplace.

VI. Tariffs and the current trade war with China

The fifth step that needs to be undertaken is an effort to defuse the escalating trade hostilities between the United States and China. More than half of Chinese imports now face punitive import tariffs. The tariff rate on $200 billion of Chinese imports was set to climb from 10 percent to 25 percent on Jan. 1, 2019, and President Trump threatened on Sept. 17, 2018, to “immediately” place tariffs on another $267 billion worth of imports “if China takes retaliatory action against our farmers or other industries.” Tariffs are a tax on U.S. consumers and it is not at all clear that additional U.S. duties will work to disrupt China’s industrial development through its Made in China 2025 program.

Fortunately, a major thaw in the tariff war with China occurred at the G20 meeting in Buenos Aires on Dec. 1, 2018, when President Trump decided not to raise tariffs on $200 billion of Chinese imports from 10 percent to 25 percent on Jan. 1, 2019, as had earlier been threatened. In return, President Xi Jinping of China agreed to “immediately” begin discussions on China’s industrial policies, including its coercive licensing of U.S. technology, trade secret theft and nontariff barriers to trade. The agreement has a 90-day deadline for review, which will occur on March 1, 2019. It remains to be seen whether China will live up to its undertakings, and whether the United States will be satisfied with what China offers by March 1, 2019.

VII. Conclusion

The objective of U.S. trade policy should be the containment of China, which must be undertaken through patient, persistent pressure on a variety of fronts. President Trump has said that trade wars are easy to win, and he believes he can wreck the Chinese economy, as Reagan outspent the USSR on defense. He is wrong. While the pace of Chinese economic growth has fallen by half since 2007, China is not the Soviet Union Reagan faced down in the 1980s, any more than it is Japan in 1941, desperate for the oil that President Roosevelt embargoed. It is large enough to supply itself with most of what it needs to survive.

Furthermore, the Korean War demonstrates that when China feels its vital interests are being threatened it can and will lash out at the West with devastating consequences.

China’s name for the United States is Meiguo, the beautiful country. The history of China’s relationship with the United States is one of hope followed by disappointment, but at the end of the day the Chinese people still view America as the beautiful country.

The result has been interdependence, and an entangling embrace that neither can quit. As John Pomfret has pointed out, the relationship between the United States and China “is powered by love and hate, contempt and respect, fear and awe, generosity and greed.”

The only constant in international relations is change, and it is the job of statesmen to manage change for the better. The relationship between the United States and China has permanently changed. China is no longer a developing country, entitled to undertake one-sided policies counter to the interests of the United States. It is a rising power that needs to be contained within the norms of a rules-based system. Critics have noted that thus far President Trump has not demonstrated that he has either the foresight or the discipline required to carry out the patient, persistent policy of containment outlined in this article. But Trump will not be president forever. While he remains in office, the elements of containment described herein must remain the order of the day.

Hard Brexit

Graphic combing photo of London with dark clouds the EU flag and the Union Jack

One of the truisms of modern politics in the U.K. is no one is surprised by anything. Not the confidence vote in Theresa May, not the postponing of Parliament’s vote on the withdrawal agreement, and certainly a general election in the near future would not be surprising. Since 2016 at least, it as often felt like we have entered ‘the twilight zone’, where any outcome is believable, and all bets are off. So, for those who have not been following the ins and outs of British politics, there might be cause both for a quick recap of where we in the U.K. have got to, and for a pause for breath, as we consider how the next year of Brexit may well play out. And let me lay it out at the start: nothing would surprise me.

How we got here is a long story, but it can be summed up in a few key dates. Clearly, the referendum of June 23, 2016, when the U.K. voted to leave the European Union, is among them. Next of course would be March 29, 2017, when the official notification that the U.K. would be leaving the EU was submitted under Article 50 of the Treaty on European Union, starting the two-year countdown. Then June 8, 2017, when Theresa May lost her narrow parliamentary majority in a snap election that she had no need to call (and having enjoyed a 20-point lead going into the last weeks of campaigning).

When the history of Brexit is written however, Dec. 8, 2017, might be considered the most crucial. This was the date on which the U.K. and EU teams published their joint report on progress in negotiations, and it was this that largely set the parameters which have determined the negotiations since. Most particularly, the U.K. agreed in principle here both the so called ‘divorce bill’ of £39 billion, and the even more contentious Irish Backstop. This was where, in the absence of agreed solutions, the U.K. committed to “maintain full alignment with those rules of the Internal Market and the Customs Union which, now or in future, support North-South cooperation, the all-island economy and the protection of the 1998 Agreement.” In effect, the U.K. had made itself responsible for both sides of the border in all future negotiations.

When the U.K. failed to contest this interpretation of the joint report, we boarded the Brexit rollercoaster that took us through Chequers 1, 2 & 3 (where the cabinet debated what they wanted from the exit terms and future relationship with the EU), intensive and secretive negotiations between the U.K. and EU, leading us to the draft withdrawal agreement that the U.K. and EU published on Nov. 14 of last year. There may have been twists and turns along the route, but the end result always looked to be a customs union and with high regulatory alignment as a backstop to ensure no hard border on the island of Ireland, pending a future agreement to be negotiated that would “build and improve upon” these arrangements. And such a result was always going to be highly contentious in parliament.

Text in quotes: The pre-scripted part of Brexit, if there was one, is over; what happens now will be determined by political decisions.How much of these developments were down to U.K. incompetence, conspiracy, or the inevitable difficulties of the negotiations given the parties starting points depends on whom you ask. Personally, I am suspicious of both the conspiracy narrative, and the notion that these things are purely deterministic. Either way, we have now reached the “end of the track.” The pre-scripted part of Brexit, if there was one, is over; what happens now will be determined by political decisions.

At least in the media, all options are on the table. Some favour so called “Norway +,” which might actually be termed “Norway –” as it involves staying in a customs union; others would prefer a second referendum, although how to achieve one without a general election seems a mystery.

The prime minister’s withdrawal agreement, hated by parliament as it is, is still alive. But were I to offer my two cents, the only option ahead with a clear path, and requiring no new legislation in parliament, is some form of ‘Hard Brexit.’ As such, it is increasingly important to consider what such an outcome might comprise.

By Hard Brexit I mean the U.K. leaving the EU on March 29 without a withdrawal agreement. Unlike most other options, this does not require the cooperation of the EU to proceed. In this scenario, the U.K. leaves both Single Market and Customs Union of the European Union at 11 p.m. on March 29, 2019, along with leaving the various political institutions of the EU and the jurisdiction of the Court of Justice of the EU. Because cooperation with the EU is not taken for granted here, the potential for disruption, from aircraft landing rights to derivatives contracts and the supply of medical isotopes, is massive. World Trade Organisation (WTO) rules are relatively limited in scope and do not address many of the most difficult issues concerning non-tariff barriers, border frictions and services trade.

There remain, however, a large number of mitigating actions that can be taken unilaterally, while many of the more alarming warnings of no cooperation at all can be dismissed as fanciful. A more believable ‘no deal’ Brexit might look as follows.

Firstly, planes will continue to fly. The U.K. possesses the world’s third largest aviation network and the European Commission has already confirmed that it will take steps to ensure that air services will continue. Major airlines clearly accept this and have been selling post Brexit tickets for months. The same is true of other areas where outright non-cooperation would be damaging. At the time of writing, the Commission is doing all it can to publicly rule out this sort of “managed no deal,” yet in doing so has stated that it would unilaterally extend agreements in selected sectors, including for financial services, following a WTO exit.

Although the Commission has urged member states to refrain from exercising their national powers to make bilateral agreements with the U.K., one could reasonably expect further agreements, possibly at the 11th hour in March or shortly following an exit on WTO terms as described above. These would likely cover citizens’ rights, road haulage, and facilitated customs checks for certain classes of goods, and would be negotiated with the member states with which the U.K. does the most business. In the most optimistic scenario, the U.K. and EU strike a last-minute agreement to begin full free trade agreement (FTA) negotiations, under Article 24 of the WTO General Agreement on Tariffs and Trade. This would allow for provisional tariff free access for UK goods into the EU market. In reality, triggering Article 24 would require fairly advanced plans for such an agreement, and so it is more likely that U.K. goods would face tariffs exporting to the EU 27. However, on average, such tariffs are relatively low for non-agricultural goods and could easily be compensated by an expected devaluation of the pound. The issue is non-tariff barriers and administrative costs and frictions. There are good arguments that the EU would be in violation of WTO rules by imposing full third-country regulatory controls on U.K. goods, while our respective regulations remain the same, but this would not be quick or easy to resolve. Northern Irish traders exporting to their neighbors in the Republic of Ireland would be particularly hard hit, if the EU maintained its current course, even if the U.K. government stood by its pledge not to introduce border infrastructure.

But it Is worth bearing in mind here just how much the U.K.’s economic success depends on actions taken in Britain. While the EU accounts for over 40 percent of U.K. trade, imports are a significantly larger part than exports (£341 billion vs £247 billion). How these are treated will be down to us, and the government has already promised to continue recognising EU standards in sectors such as medicines. EU exports on their own still comprise between 13 percent and 14 percent of the economy as a whole, however much of this takes place in services, where Single Market provisions are patchy. In fact, before leaving became an explosive political issue, most analyses of the costs and benefits of the U.K. leaving were pretty much a wash. Estimates were plus or minus one or two percentage points of GDP; a far cry from recent pronouncements from the Treasury. Even so, there will still be significant opportunities available as a result of leaving the EU that would benefit the U.K. economy.

The first of these actions is to move quickly towards unilateral free trade, particularly in sectors where the U.K. is a net importer. If you had been paying attention to debates in Parliament, you might have gained the impression that the U.K. economy depends primarily on cars and fish. In reality, these two sectors added together constitute less than 1 percent of U.K. GDP. The same is also true of agriculture, and other high tariff sectors such as clothing and footwear are likewise small segments of the U.K. economy. Reducing these tariff barriers has long been hailed as one of the key potential benefits of Brexit. Such a move would lower prices for consumers and reduce the cost of inputs for other sectors of the economy.

The second set of reforms that would be enabled by leaving involve the replacement or repeal of various EU rules. Using the governments own impact assessments, the cost of EU regulation on the U.K. economy easily runs into the tens of billions of pounds annually. Many expensive rules on financial services, such as CRD IV and AIFMD, and certain aspects of environmental and labour law should be reformed or repealed if the U.K. is to become more competitive. These laws can also be more damaging than the significant costs make them appear due to anti-competitive effects on small and start-up businesses that are almost impossible to capture.

Ultimately, the most significant factor will be domestic policy decisions by the U.K. government, particularly in areas of taxation and housing. This may be fairly unexciting news at the end of an article about Brexit, but if the U.K. is to succeed as a “free trading, buccaneering nation,” such success will depend in large part on the ability of companies to attract investment through low corporate taxes, and the ability of workers to move to where they will be most productive through further housebuilding in key areas.

The objection to such calls has always been that it is not politically feasible. Interestingly though, and perhaps as an unexpected consequence of the conversation surrounding Brexit, that may be changing. A recent ComRes poll found that, although divided on almost every other aspect, a clear two thirds of voters agree that when Brexit is complete, “the U.K. should try to become the lowest tax, business-friendliest country in Europe, focused on building strong international trade links.” Against all expectations, the view is even held by a majority of Labour voters (54 percent). Might the country be prepared to embark on a pro-free trade, lower tax and de-regulatory agenda? Well, as I said at the start, nothing would surprise me.

Who should run the banks?

Cayman Financial Review Logo

The financial crisis whose tenth anniversary we have just commemorated led many people to worry about the seeming asymmetry of rewards in the banking system. It was said that the gains to banks in the run-up to 2008 were privatized, while the losses as boom turned to bust were socialized. Bankers reaped ever higher bonuses, while taxpayers picked up the tab.

This account is true as far as it goes, but it overlooks another asymmetry that arguably played a more important role in the crash. That is the fact that financial institutions are privately owned, but much of their activity falls under the control of the government. This effective separation of ownership from control, a decades-long process, has created a perverse incentive structure that makes the financial system more fragile.

Turning banks into an arm of the government

In a recent New York Times column, Andrew Ross Sorkin outlined ways in which credit card companies, by collecting and reporting data on customer purchases in much greater detail than they do at present, could “[push] for more responsible practices by the gun industry.”

As we will see, there is nothing new in the suggestion that financial services firms should act as surrogates of the government. Yet the assumption that a natural way to address the problem of gun violence is to force payment companies to gather, quite indiscriminately, sensitive private data shows the extent to which many people view banks and other financial firms as public utilities.

Sorkin’s is not an isolated voice. Following a school shooting in Florida last February, Bank of America and Citigroup – the second- and fourth-largest U.S. banks by assets – announced new requirements from the gun retailers whom they bank. Their move drew heavy criticism from the National Rifle Association and Republican lawmakers. “Citigroup took $470 billion from the American taxpayer […] Bank of America took $340 billion. I don’t remember them saying, ‘Oh, we don’t want the money from taxpayers who believe in the Second Amendment [which protects the right to own guns],’” quipped Senator Kennedy from Louisiana.

The senator’s critique was characteristic of conservative opposition to the banks’ new gun policy. It focused not on their business freedom and the right of concerned customers to switch suppliers, but rather on the perceived injustice that beneficiaries from the generosity of taxpayers in times of crisis would ostensibly act to undermine the constitutional rights of those very taxpayers. Conservative Kennedy and liberal Sorkin both echoed a long-standing view in American public policy: that financial institutions are not ordinary private firms, but privileged entities with a duty to act on behalf of the government.

America’s very political banks

Banks for most of modern history in most countries have not operated in anything resembling a free market. Bank charters, which authorize their holders to take deposits and lend them out, are typically government-granted. States are in some cases the biggest bank debtors, enjoying the political muscle to extract lenient loan terms from their creditors. Usury laws for centuries constrained heavily the rates that banks could charge as interest. More recently, the capital and type of assets that banks may hold on their balance sheets have become a matter of statutory regulation.

In these and other ways, governments determine the volume and allocation of credit in the economy. The result has been not an arm’s length relationship between banks and public authorities, but a tight partnership whereby banks acquiesce in financing governments and their clients, while governments shield banks from competition and underwrite bank balance sheets. Financial historians Charles Calomiris and Stephen Haber have called this quid pro quo “the game of bank bargains.”

The United States, paradoxically given its status as a beacon of free enterprise, illustrates the persistence yet changing nature of this game. A key reason why America has historically had an unusually large number of small banks was that agricultural interests, which dominated American politics in the 19th century, pushed for branching restrictions in a bid to force banks to provide credit locally. In addition, before the creation of the Federal Reserve in 1913, banks could only issue notes up to the value of their U.S. Treasury bond holdings.

America’s banking system was thus inflexible, inefficient, and crisis-prone due to its fragmentation. Banks could not scale up and diversify their lending geographically, nor respond to seasonal fluctuations in money demand. Between 1833 and 1933, the United States suffered eleven major banking panics – sudden spikes in demand for currency notes relative to deposits. Canada, which by contrast had a smaller number of much larger and nationally active banks, and no restrictions on note issuance, experienced many fewer bank failures. It is worth recalling that no Canadian bank failed during the last financial crisis, either.

The symbiosis between banks and public authorities played out in different ways for different institutions. Small banks lobbied politicians to preserve their local monopolies. Wall Street banks, which thanks to branching restrictions maintained a lucrative correspondent business, lobbied for the creation of the Federal Reserve not for the public’s benefit, but to keep this business while securing a source of emergency liquidity during panics. Far from stemming financial instability, regulation insulated banks from some of its dire consequences by transferring risks onto taxpayers.

How successful was New Deal financial regulation?

The decades from the 1930s to the late 1960s are remembered as ones of historically unusual financial stability. No major banking panics occurred and the U.S. economy grew strongly, punctured by frequent but shallow recessions.

It is difficult to establish the extent to which bank regulation enacted after the Great Depression was responsible for the three decades of comparable calm that ensued. After all, the period following World War II was a time of growing prosperity across the West, including in countries whose banking systems shared little with America’s. Furthermore, stagflation in the 1970s put an end to both strong growth and bank stability, as rising rates to cope with double-digit inflation raised banks’ cost of funds while keeping returns fixed on their existing assets, such as home mortgages.

What is plain is that New Deal legislation strengthened the quid pro quo between U.S. banks and the government in ways that have proved decisive in more recent crises. Bank deposits became federally insured in 1933, creating a potential taxpayer liability in the event of bank failure – an implicit guarantee that politicians have since used to justify new regulations. In addition, housing finance was part-nationalized with the creation of Fannie Mae, a government agency tasked with boosting the liquidity of mortgage markets by buying up housing loans from banks. New Deal legislation also set an interest-rate ceiling on savings deposits that lasted into the 1980s, and an interest ban on demand deposits that was only repealed in 2011.

The New Deal seemed a sweet deal for U.S. bankers, as their funding was subsidized by deposit insurance and interest caps, while they guaranteed themselves a willing buyer for a large share of their loans. But it came with strings attached: banks became clients of the government and thus vulnerable to future demands to do the politicians’ bidding.

Those demands, predictably, have mounted. In 1970, Congress passed the Bank Secrecy Act (BSA) in a bid to fight money laundering by criminals. The BSA’s provisions and mandates have gradually expanded, especially after the 9/11 terrorist attacks. Estimates of the compliance cost to banks range between $4.8 and $8 billion.

BSA regulations are onerous because they require banks, money transmitters, securities dealers, insurance companies, and many others to file a report each time they process transactions above a certain amount. The thresholds vary by institution, but they range between $2,000 and $10,000 and have not been adjusted for inflation since 1970. The political sensitivity of the crimes that the BSA purports to prevent, and the stiff penalties associated with non-compliance, mean banks spend vast resources to ensure they are on the right side of the law.

Another milestone in the U.S. government’s creeping takeover came in 1977 with passage of the Community Reinvestment Act (CRA). This law aimed to promote credit to low-income and minority borrowers by mandating that banks lend in the communities where they take deposits. At the time, red-lining (the practice of denying credit to borrowers in certain geographies) was a widespread problem in America, particularly for blacks. The CRA sought to eliminate red-lining by placing a new mandate on banks. In the words of Senator William Proxmire, who championed the legislation: “Those who invest in new deposit facilities receive a semi-exclusive franchise […]. The Government limits […] entry […] restricts competition and [limits] the rate of interest payable on […] deposits. The Government provides deposit insurance through the FDIC […] The regulators have […] conferred substantial economic benefits on private institutions without extracting any meaningful quid pro quo for the public.”

One is reminded of that scene in The Godfather: “Some day, and that day may never come, I’ll call upon you to do a service for me.” U.S. banks have seen many days like that.

When bank branching was finally liberalized in the 1990s, the CRA became a tool by which activist groups could put pressure on banks wishing to grow or acquire another institution, since regulators must take CRA performance into account when deciding whether to authorize a bank’s expansion. Between 1992 and 2007, banks made $4.5 trillion in CRA lending commitments, some of them under terms they would not have otherwise offered. But pleasing regulators can sometimes be better for a bank’s bottom line than lending prudently on market terms.

Did we learn anything from the 2008 crisis?

Policymakers like to say that the measures taken to shore up bank capital and improve the quality of balance sheets mean a financial crisis like the one experienced a decade ago is inconceivable today. Yet despite these proclamations, much of the pre-crisis regulatory landscape is unchanged.

Bank deposits not only remain government-insured, but the limit on insurance was raised from $100,000 to $250,000 during the crisis. Thus, depositors have little incentive to monitor bank safety, and banks are not spurred to market themselves to potential depositors as well-capitalized and prudent. What is more, research by Calomiris and Sophia Chen shows that more generous deposit insurance increases bank risk-taking and financial fragility.

Mortgage lending, more than at any time since the 1930s, is a government activity. While banks hold more of the mortgages they issue on their balance sheets than they did in the run-up to 2008, that share is less than a third. The rest is securitized by the government-sponsored enterprises (Fannie Mae and Freddie Mac) or other public entities. The CRA continues to encourage mortgage lending to low-income borrowers, and the median down payment remains at a historical high of 94 percent.

Complex regulation has encouraged concentration. The U.S. banking system has fewer banks than it did in 2008, and the largest ones are larger than ever. Concentration on its own is no problem. But it is difficult to take seriously policymakers’ claim that the government’s implicit guarantee has been broken when the failure of any major bank might expose the financial system to greater turmoil than during the last crash.

Politicians, especially after the crisis, claim to want to “make banking boring again.” But their actions say otherwise: what politicians wish is for banks to do their bidding. For example, periodic revelations continue to emerge of the U.S. government’s drive, under the Obama administration, to pressure banks into refusing service to controversial organizations such as gun shops and payday lenders, in what became known as Operation Choke Point.

What is most concerning about such overreach is that it has managed to impose its terms on the opposition. Most of those who have criticized Choke Point do so claiming banks are essential facilities, like an energy utility, and thus should not be allowed to refuse service to customers. That is not the point, though: banking is a competitive industry, not a natural monopoly. The outrage of Choke Point is that the government is directing private-sector firms to act in this fashion.

However misguided, this attitude is in keeping with a history of increasing government control of financial institutions. The trend, despite many deleterious consequences, has not stopped. It is difficult today to find a country that does not run its banking system on the assumption that it is an arm of the government.

There are, however, examples of countries with stable financial systems that lack America’s myriad interventions. Israel, New Zealand, and Panama have no government insurance of bank deposits. Canada historically lacked the barriers to consolidation prevalent in the United States, resulting in more diversified bank balance sheets. Many European countries have gone without schemes to promote mortgage lending. Indeed, it was jurisdictions that had turned homeownership into a political imperative, such as America and Spain, that experienced the most damaging housing crises from 2006 onward.

It is difficult to wean politicians off the tendency to use the banking system to further their own objectives. Banks often often happy to go along during the good times, as their likelihood of a taxpayer-sponsored rescue in bad times increases. Yet, if we carry on this way, soon we will find ourselves with a banking system as safe as the bailed-out insurer AIG was in 2008, and as innovative and customer-focused as the postal service. Not your grandmother’s boring banks.

OECD not up to fighting modern trade challenges

Cayman Financial Review Logo

The global trade system is under assault thanks in large part due to the election of Donald Trump as U.S. president. His pledge to “put America first” has been carried out through tariff hikes, U.S. withdrawal from the Trans-Pacific Partnership (TPP), an attempt to replace NAFTA with a new agreement featuring added protectionism, particularly on the automotive industry, and threats to withdraw from the World Trade Organization.

The danger is exacerbated by the concurrent global rise of illiberal populism, along with its distrust of foreigners and skepticism of multilateral trade agreements. It would be beneficial for there to exist a global body focused on responding to these anti-trade headwinds.

Unfortunately, the most obvious choice – the Organization for Economic Cooperation and Development (OECD) – has drifted so far from its original mission as to no longer be up to the task.

Future of global trade uncertain

It is possible that the Trump administration represents an aberration, both within the U.S. and globally. It is likely, for instance, that the next U.S. president will be more favorable toward trade, which opinion polling shows has gained popularity among the American electorate under Trump, though whether Democrats maintain their newfound appreciation for free trade after Trump remains to be seen.

And perhaps the rest of the world will continue making progress on economic liberalization without the U.S., as happened when the other nations involved in the TPP negotiations formed their own pact after the U.S. withdrew its signature.

But other more concerning possibilities exist. Populist movements are spreading, particularly in Europe where support for populist parties has been steadily growing for 20 years, well before the emergence of Trump. Should they gather enough momentum, the liberal global order may be in real trouble.

The yellow vest protest in France have turned violent, and while hard to pin down ideologically, appear increasingly hostile to “globalism.” Populist candidates have also recently won elections in Brazil, Italy, and Hungary, among others. Trade has not played a significant role in all these cases, with cultural or other domestic issues often proving more salient, but the very rise of illiberalism is inherently threatening to open trade.

The OECD response to these developments, unfortunately, has proven disappointing. Instead of returning to its roots by refocusing on its core mission to foster economic cooperation and open global markets, the OECD has gotten only more ideological and doubled-down on its misguided commitment to expansive government.

The OECD became tax bullies

Pervasive mission creep at the OECD began in earnest with its efforts to limit what it considers “harmful tax practices.” In Cartelizing Taxes: Understanding the OECD’s Campaign against “Harmful Tax Competition,” published by the Columbia Journal of Tax Law, Andrew Morris and Lotta Moberg trace how the OECD’s involvement in tax policy evolved from an “initial focus on finding solutions to problems that impeded international economic activity to a focus on protecting a few states’ abilities to collect revenues at the expense of other states.”

The shift from primarily reducing the friction between the different trade and tax policies of member nations to actively pressuring non-OECD members – in particular, low-tax jurisdictions and offshore financial centers – into adopting policies favorable to the high-tax membership of the OECD has proven consequential. For global tax policy, it has meant a steady erosion of financial privacy rights and the proliferation of intergovernmental information sharing, first on demand but more recently on an automatic basis.

It has also produced a massive global undertaking on corporate taxation through the Base Erosion and Profit Shifting (BEPS) project. Even though global corporate tax revenues had not declined, the OECD insisted BEPS was urgently needed and for years now has devoted considerable resources to the project, with no letup in sight. And the newest tax-related obsession of the OECD is digitalization, itself an outgrowth of BEPS, as the OECD is deeply concerned with the prospect that any future economic activity might occur unimpeded by the frantic grasping of tax collectors.

Expanding well beyond tax

Since Morris and Moberg published their study in 2012, the OECD’s ideologically-motivated drift has only accelerated. That same year, the OECD started its “Inclusive Growth” project in partnership with the left-wing Ford Foundation. Inclusive Growth, which prioritizes relative measures of prosperity like inequality over absolute welfare, has become a top focus of OECD activity, providing the framework through which a growing number of policy analyses and recommendations are delivered. This in turn has allowed the organization to expand into all manner of policy areas, such as climate change, gender politics, healthcare and diversity.

Its work on tax policy has also degraded, with it increasingly recommending destructive changes. The Framework for Policy Action on Inclusive Growth, for instance, lauds “redistributive fiscal policy,” and calls for higher death, gift, and capital gains taxes. Such recommendations often place the OECD’s increasingly prominent political arm at odds with its own economists.


Morris and Moberg concluded that the OECD “offers an arena for networking and informal opportunities for changing sentiments without media scrutiny,” and noted the convenience offered by an organization incorrectly considered to consist solely of “technocrats not under the political influences that many of their peers in other organizations are.” They predicted, “as long as politicians show a willingness to pursue policies through the OECD, the people of the organization will seek to expand the mission of the organization and form it to an even more attractive arena for making policies.”

Boy, were they right. In blowing past the boundaries of its founding mission and diving into contentious domestic policy debates, the OECD has undermined its authority on trade. While it has by no means dropped trade from its agenda, the OECD today lacks the focus and drive necessary to face the growing challenges to globalization. As a result, there is a gaping void in the space the OECD once occupied at a time when the world desperately needs a force capable and willing to fight to preserve and strengthen real economic cooperation.

The EU Commission’s tax policy shift

Figure 1

On March 7, 2018, European Union Tax Commissioner Pierre Moscovici remarked, that the EU Commission – the governing body of the European Union – attacked what he and the Commission called “aggressive tax planning” by “seven EU countries: Belgium, Cyprus, Hungary, Ireland, Luxembourg, Malta and The Netherlands.”

Commissioner Moskovici suggested, counter-intuitively, that these seven countries “increase the burden on EU taxpayers” by keeping their taxes lower than other countries.

Since March, the EU Commission has grown increasingly impatient with low-tax jurisdictions under its realm. Therefore, on Oct. 23, 2018, the EU Commission published its Work Program 2019 where it declares its intent to increase “the use of qualified majority voting and allow more efficient decision-making in key fields of taxation and social policies.”

This move, would constitute a major shift in the status of the European Union relative to its member states. A qualified-majority rule would allow for the EU to pass new laws, including the introduction of new taxes, against the will of some member states.

There is both a constitutional and an economic side to this move, both of which will have major impact on Europe’s future. Constitutionally, the establishment of majority rule would codify the European Union as a traditional government body, as opposed to a cooperative structure for member states. That, in turn, would open for a new level of legislation with significant impact on taxation, government spending and other areas.

From an economic viewpoint, the biggest impact of majority legislation (even if qualified as opposed to simple) will will be on taxation. Commissioner Moscovici’s negative branding of low-tax states was a direct lead-up to the Commission’s declaration that it intends to pursue the majority rule. Therefore, the most important question at this point is: how high will taxes go when EU member states can no longer veto unionwide taxes?

The first clue toward the answer is in the aforementioned Work Program 2019, where the Commission sums up its view of the European economy in two sentences: “Europe’s economy is performing well. Growth reached a 10-year peak in 2017. Employment and investment have returned to pre-crisis levels and the state of public finances has significantly improved.”

The EU-wide growth rate for 2017 was 2.43 percent (2.38 for the euro zone). For the first two quarters in 2018 the average growth rate has been 2.21 percent, but there are indications of a further slowdown. So far, four countries have reported GDP for the third quarter: Austria, France, Lithuania and Spain. All of them report a decline in annual growth from the second quarter.

While unemployment has fallen to its 2008 levels, the same cannot be said for business investments. In 2007, the last year before the Great Recession, investments grew by 6.2 percent, EU-wide, in real terms. The average for the four quarters Q3 2017 through Q2 2018 was three percent. Since business investments start falling a year before a recession, 2007 is the appropriate point of comparison.

Public finances have indeed improved in the sense that deficits are much smaller – in some countries replaced with surpluses – but this has not come through economic growth. For the EU as a whole, government revenue as share of GDP has risen from just above 43.5 percent in 2008 to almost 45 percent in 2018. The reduction of deficits has happened on the shoulders of taxpayers and at the expense of economic growth.

This last point is important in the context of the EU Commission’s campaign for easier tax legislation. At no point has the Commission expressed concerns over the impact of high taxes on the European economy – quite the contrary, in fact. The EU has an established record of hostility toward low-tax jurisdictions: in 2015, Dan Mitchell exposed a black list, produced by the EU, of what it considered to be “the world’s 30 worst-offending tax havens”.

I followed up on Mitchell’s analysis in the January issue of the Cayman Financial Review: “The European Union has created a new kind of blacklist of 17 jurisdictions, and a “watch list” of another 47, branded as “tax havens” or “noncooperative” countries and territories. This list, which has been long in the making, vilifies countries and territories for no other reason than providing residents and investors with low taxes and financial privacy.”

Several countries aspire for the title as the highest-taxed country in the EU. Currently, in six countries government revenue claims more than half the economy: Belgium (57.4 percent of GDP), Finland (55.0), France (54.8), Denmark (52.6), Sweden (52.0) and Austria (50.4).

By contrast, Malta, Slovakia, the U.K., Lithuania, Spain, Cyprus, Romania and Ireland all maintain government revenue below 40 percent of GDP. As I explained in the January article, the tension between high- and low-tax EU countries is growing; with it, so is the intolerance of the EU Commission toward the persistence of comparatively low taxes within its jurisdiction.

Romania is a telling example of what this intolerance can lead to. In 2005 they substantially reduced income taxes, leaving a progressive system behind for a flat tax. The top rate of 40 percent was replaced with one 16 percent rate. Corporate income taxes were cut from 25 percent to 19 percent. The effect on the Romanian economy has been substantial: After a growth spurt in the early years after the Millennium Recession, it lost steam toward 2004-2005; after the tax reform it sustained annual real growth rates in excess of six percent for almost three years. See figure 1

Figure 1 - Government spending, tax revenue, percent of current-price GDP

Low taxes have undoubtedly played a key role in bringing the Romanian economy back to high growth after the Great Recession.

The effect of the tax reform is even more pronounced in business investment data:

  • Already in the second quarter of 2005, capital formation accelerated sharply, exceeding eleven percent on an annual basis;
  • For 2005 the Romanian economy saw businesses grow investments by 13.6 percent, followed by 20 percent in 2006, 49.6 percent in 2007 and 20.1 percent in 2008;
  • Meanwhile, the EU as a whole experienced investment growth at 3.5 percent in 2005, 5.8 percent in 2006 and 6.2 percent in 2007.

The EU entered the recession in 2008; notably, the Romanian economy got an extra year of growth before it followed suit.

It is not difficult to imagine what substantially higher taxes would do to the Romanian economy. However, enforcement of economic conformity from Brussels would not be limited to high taxes. Current variations in taxes in the European Union are the result of different policies regarding government spending.

It may seem like a redundant point to make, but the reason why taxes are high in the EU in general is that most of its member states have elected to create and maintain large welfare states. The most prominent feature of a welfare state is a large, complex set of entitlement programs that drive government spending; to fund those programs, governments need high taxes. Countries that keep taxes low can do so because they hold back government spending (non-EU countries included for comparison): See figure 2

Figure 2 - Ral GDP Growth: Romania vs. EU Average

Lower levels of welfare state spending tend to correlate with higher growth, both in the economy as a whole and in personal income and wealth. Tax competition forces big welfare states to rethink their ambitions in terms of economic redistribution. Therefore, regardless of whether the EU leadership wants to or not, their campaign against low-tax jurisdictions is de facto an ideological declaration in favor of egalitarianism.

This political preference helps explain the antipathy in Brussels against tax competition. If the Commission can use qualified-majority legislation against low taxes, it can eliminate the macroeconomic advantage that those countries can offer vs. larger welfare states. Thereby, big spenders like the Nordic countries, France and Belgium will no longer have to fear economic competition from member states that put more emphasis on economic freedom.
A qualified-majority vote system would also allow the EU to create its own welfare-state budget. Funded by EU-level taxation – the next step in the campaign against low taxes – it would neutralize attempts by individual member states to put personal responsibility and economic choice over tax-paid entitlements.

The desire to “harmonize” social expenditures across the EU were expressed already around the time of the formation of the Union. Over time focus has been primarily on synchronizing legislation, but shifted more recently in favor of spending. In 2016, the EU published a report by the so-called High Level Group on Own Resources that argued for a bigger EU budget. Part of the purpose was to increase spending for “social sustainability” and “social inclusion”. The report made clear that the path to a bigger welfare-state budget for the EU was taxation at the EU level.

The idea of bigger welfare-state spending was further highlighted in a May 2018 press released by the EU Commission. Proposing a “pragmatic, modern, long-term budget” for the EU, the Commission motivated its desire for direct taxation with a need to promote “social fairness”. This, the Commission explained, would further “a strong and stable Economic and Monetary Union.”

It remains to be seen how the “harmonization” of government spending across Europe will change the way entitlements are designed and funded. It is not far-fetched to assume that there will be EU funds designated for the purposes of social expenditures, such as health care, welfare and general income security. Those funds would come with strings attached, regulations that de facto extend the high-tax cartel into a welfare-state cartel. While the details, again, are a bit speculative, the developments on the spending side of the EU budget are going to be indicative of how far they will go in formalizing the campaign against low taxes.

Fortunately, there is a silver lining in the EU Commission’s communications about taxes and majority votes. They have not sprung their intentions on the public, and on investors, over night. The current plan is to build support for the qualified-majority reform over the next several months, toward a planned implementation date in May 2019.

It is unlikely that a majority-vote reform itself will have any immediate repercussions on the willingness to invest in Europe. The economic consequences will materialize as new legislation goes into effect. However, the close ties between the push for a majority-vote system and the campaign against low taxes is a red flag worth taking seriously. One might even ask if the majority-vote reform would be this high on the EU Commission’s agenda were it not for their very plans to eliminate tax competition in Europe.

Prudent investors can start rethinking their commitments in Europe already now.

Unfortunately, Europe’s middle class does not have that option. They will be the big losers as the Eurocrats in Brussels ramp up their attacks on the forces of economic freedom and prosperity.

Sven R Larson, Ph.D., associate scholar, Center for Freedom and Prosperity

And the solution is: adopt global best practices

Clothes pegs holding up three scraps of paper with GOOD, BETTER, and BEST written on them.

What is the optimum size of government as a percentage of GDP? And what is the optimum number of elected representatives per million people? At what point is the number of people represented by one elected official so large that effective democracy ceases to exist?

People throughout the world moan that “government is too big,” yet the people voted for those who have made government too big. Occasionally, those in the majority realize they have made a mistake and they take steps to correct – Brexit being a current example. The British thought they had lost control over their own lives and government, which indeed they had. They were being micro-managed by non-British bureaucrats from afar – and finally they said, “Enough is enough, and damn the consequences of a pull out.”

Legislative bodies spend billions of taxpayer dollars in large lumps that no one understands. The average taxpayer probably has some notion of how much a local school should cost, but not a warship or large hospital center. They do understand that most of their elected representatives also have no idea of how much most of things they spend taxpayer money on should cost. This disconnect only gets worse as there are fewer elected representatives for each dollar spent. The result is greater and greater alienation between the voters and the government.

Over the last 40 years, a number of researchers have looked at the optimum size of government as a percentage of GDP (I did my first paper on the subject in 1986). Optimum size can mean different things to different people. It can mean the point at which economic growth begins to slow because of government drag. It can mean the point at which social welfare on a per capita basis is no longer growing. Or it can mean the point at which the loss of liberty due to more government exceeds the benefits of paying for liberty-enhancing activities such as a court system and protection of one’s person and property. Most studies have shown that once government exceeds approximately a quarter of GDP, the negatives of more government exceed the positives.

Comparisons of one government to another are difficult because of endless definitional problems, and the fact that countries vary widely as to which activities are done by government rather than the private sector. See table 1


As can be seen in Table I, some of the most successful countries, in terms of per capita income and other variables, have relatively small government sectors. France, for instance, has a government sector of about 50 percent of GDP, yet it has a real per capita income of only about two-thirds of that of the U.S. and far less economic freedom.

Singapore and Hong Kong have per capita GDPs higher than that enjoyed by the typical U.S. citizen, but spend relatively only half as much on government activities as in the U.S., with better outcomes in terms of life expectancy and educational attainment. It is correctly argued that these jurisdictions spend little on defense, unlike the U.S., but even adding another two to three percent of GDP on defense spending to bring them up to relative U.S. levels would still give them governments of only about 20 percent of GDP.

International organizations such as the OECD, IMF, and UN often argue that countries need to tax and spend more to cure whatever ills that are alleged to beset them. There are a few countries that are so poor and dysfunctional that they have governments too small to meet the necessities – but these are relatively rare cases. Again, international bodies frequently recommend that even countries with governments that exceed 20 percent of GDP, should tax and spend more. Such recommendations are close to economic malpractice, given that bigger government is more likely to add to problems rather than reduce them. The additional spending almost always occurs while the expected tax revenues often fall short, because the international experts consistently underestimate both the role of incentives and disincentives.

The result is the country is saddled with more debt, which becomes a future drag on economic growth.

One of the great curses of modern government is the tendency of the political class to spend more than tax revenues provide. The result is ever-growing debt burdens with a number of countries, such as the U.S., approaching net public debt burdens of 100 percent of GDP, and in a few cases, such as Japan and Italy, greatly exceeding it.

Fortunately, there are a number of democracies that so far have avoided burying themselves in debt, and thus can serve as best practice good examples. The Scandinavian countries all spend more of their GDP on government than is optimum, but even so have managed to be fiscally responsible in terms of adding to their debt burden. Denmark and Sweden are two best practice examples of responsible big government. Norway, with all of its oil reserves, has been running a huge budget surplus for decades, which they have put into a sovereign wealth fund to protect future generations. Norway may be the poster child for good behavior, while Venezuela, the country with the world’s largest oil reserves, is the poster child for bad behavior. Table II gives some examples of best practices, and a couple of countries – the U.S. and Japan – as examples of bad practices. See table 2


The effect of large debt accumulation is to reduce the amount of productive capital investment available at lower interest rates. The lack of investment, in turn, reduces economic growth and real incomes for the majority.

Life expectancy is a good proxy for both the level and quality of medical services. The U.S. spends by far and away the highest percentage of its GDP on medical care, yet the outcome of all of that expenditure is, to say the least, disappointing. As with education, the U.S. does have the best the world has to offer in medical care, but some significant parts of the population do not receive it, or as too often the case, have such dysfunctional life styles that they fail to partake from what is offered. See table 3


Best practices are more common among smaller countries, perhaps because many of them are relatively homogenous and have more representative democracies. Part of the problem with very large democracies is the number of elected representatives remains relatively fixed while the population continues to grow. Each member of the U.S. House of Representatives now represents about 750,000 people. When the first apportionment bill took place in 1793, each House member represented about 37,000 people. For the next century, even though the population grew, the number of representatives also grew, but finally it was decided that the number was getting too large to manage and so representatives were capped at 435.

The U.S. has about 326 million people, so it is exceedingly difficult for any one person to be able to meet with their member of Congress if they are not very well connected, despite having the Constitutional right to present “grievances” to their elected representatives. See table 4


The Swiss may have come closest to solving the problem of how to give the average citizen a voice in a functional way that can be emulated by other countries. The Swiss understand that most of the functions of government that impact citizens’ lives occur at the local level – schools, local roads and other transportation issues, police and fire services. For the most part, these decisions are made at the local level in small enough governmental units – communes – whereby the citizens actually know and interact with the elected representatives responsible for the governmental activities. Most other governmental functions are handled at the next level of government – cantons – and only a few matters are handled at the national level, such as defense and foreign policy. Major issues are subject to referendums with the requirement that not only a majority of voters to say “yes” but also a majority of the cantons.

Switzerland, like the U.S., is a federal republic, but the Swiss, unlike the U.S., have maintained a system where most political power and activities are at the local level.

The problems of control of government spending, taxing and regulation, debt management, education, medical care and citizen involvement have been largely solved in one country or another. Rather than being pessimistic and giving up on trying to improve the local, national, and global political situation, realize that there are answers. The wheel does not have to be reinvented, but those who are capable and willing to take on the mantle of leadership need to be pushed towards adopting the best practices from wherever in the world.

Leveraging up the global economy

The signs of the new leverage or debt crisis is here, and the window for any preventative action by regulatory and supervisory authorities is now closing fast. This was the message delivered by the IMF’s Christine Lagarde to the G20 summit in Argentina earlier in December – a message that largely fell on deaf ears of the mass media, preoccupied with geopolitical drama played out in Buenos Aires.

At the time of this article going to print, the U.S. economic cycle is in its 113th month of growth, making it the second-longest period without a recession on record. Based on core fundamentals, ranging from the long-run figures for technological and labor productivity growth to wages and consumer price inflation, from the economy’s output gap to private sector investment in physical, technological and human capital, one finds few reasons for such an impressive growth run. Slower-evolving real growth factors, such as demographic trends, international trade flows, and international aggregate demand changes are more consistent with the story of global stagnation than a robust expansion. In reality, of course, since the end of the global financial crisis, the advanced economies have experienced an unprecedented in history period of overlapping monetary and fiscal stimuli, pushing asset markets valuations to their new historical highs, while inducing ever higher leverage risks in the real economy. Funded on debt and financial engineering, this cycle of financialized growth is now coming to an end.

In a note, published in Nov. 2018, Nomura Holdings research team have looked across nineteen financial metrics that, historically, act as the leading indicators of the shifts in business cycles. Majority of the nineteen indictors are now flashing red, signaling the next recession. Factors associated not only with the rising likelihood of a recession, but also with a potential financial crisis, such as equity and credit markets’ indicators, offer an even more worrying insight.

Leveraged growth

Of particular concern are the metrics relating to corporate debt markets. Overall, based on the data compiled by HSBC, outstanding U.S. corporate debt averaged 46.3 percent of GDP in the 1960s and 1970s, rising to 58.7 percent in the 1990s and 64.5 percent between 2000 and 2008. Since the end of global financial crisis, this rose to 69.3 percent, with the third quarter 2018-figure standing at an all-time high of 74.1 percent.

Virtually all of this new debt, raised since the end of the last recession, has gone to fund shares repurchases, dividends payouts and opportunistic (as opposed to value-focused) M&As.

Per latest available data, via Yardeni Research and FactSet, S&P 500 shares buybacks are running at their highest level in history, with the 12-month combined volume of repurchases hitting $645.8 billion at the end of the second quarter of 2018. Dividend payouts are also at their all-time high of $444.3 billion over the 12 months through the end of the third quarter of 2018. At the peak of the previous growth cycle in 2007, the combined annualized rate of shares repurchases and dividend payouts stood at around $1.5 trillion. In October 2018, the number was over $2.75 trillion.

U.S. companies are not putting money into future growth. In 2Q and 3Q of 2018, S&P 500 operating earnings averaged $1.2 trillion on a trailing four-quarter basis. Buy-backs and dividends swallowed on average $1 trillion of these. From the first quarter of 2009, the last quarter of the global financial crisis, to the second quarter of 2018, larger U.S. companies have spent $4.28 trillion on share buy-backs. Over the same period of time, U.S. GDP grew by $5.3 trillion in nominal terms. Between share repurchases, M&As (at $1.66 trillion in the twelve months through 3Q 2018), and dividend payouts, major U.S. corporations have financialized $2.75 trillion worth of earnings and leverage over the period during which the U.S. economy is estimated to have grown by about $903 billion in nominal terms.

Put into the context of basic corporate finance, the U.S. economy is now carrying a massive degree of total leverage (DOTL), with a DOTL ratio in excess of 304 percent. Growth, since the end of the global crises has been underpinned primarily by government spending and debt.

Deteriorating quality of debt

Not surprisingly, the second major problem with the current growth cycle is the deteriorating quality of corporate debt.

The Nomura research note mentioned earlier, puts the key to the quality problem at the share of BBB-rated debt in the overall Investment Grade Bond Index. According to their research, thanks to the investment markets boundless thirst for yield, this stands at roughly double the historical average share. The same applies to the leveraged loans. According to S&P Global Market Intelligence, the volume of outstanding leveraged loans in the U.S. currently stands in excess of $1.1 trillion, double the 2012 levels. More than a third of the new leveraged loans issuance is going to roll over existent corporate debt, and about one fifth is underwritten to fund private equity funds’ dividends. The balance is used to fund M&As, corporate buy-outs and shares repurchases.

Unlike traditional corporate bonds and loans, leveraged loans feature floating rates, making them sensitive to the risk of interest rates increases. This risk is partially offset by the fact that leveraged loans usually are collateralized, although the quality of the underlying collateral is often dubious, especially at the times of financial market upheavals. Consider loans covenants – the terms and conditions attached by lenders to mitigate the risks associated with borrower default. Prior to the financial crisis, the majority of leveraged loans came with heavy covenants, and in 2007, covenants-constrained lending accounted for 71 percent of all corporate loans issued in the U.S., according to data from the International Monetary Fund.

For new leveraged loans, Moody’s Loan Covenant Quality Index (LCQI, a measure of strength of covenants, with higher index value reflective of lower covenants restrictions on borrowers), stood at around 2.6. In the first nine months of 2018, share of new leveraged loans issued to the U.S. corporates that had covenants attached was around 23 percent, with LCQI standing at 4.2. Both, the extent of covenants coverage of corporate lending and the quality of covenants have deteriorated to their lowest readings in history.

The story of weak covenants in corporate lending does not end here, however. As was noted by the IMF in a report published in mid-November (, weaker covenants underlying corporate loans in recent years “have reportedly allowed borrowers to inflate projections of earnings… to borrow more after the closing” of the M&A and buy-out deals.

The result? “With rising leverage, weakening investor protections, and eroding debt cushions, average recovery rates for defaulted loans have fallen to 69 percent from the pre-crisis average of 82 percent.” Moody’s latest analysis indicates recovery rates even lower, at 61 percent.

Even in the investment grade bonds markets, more than half of all outstanding corporate debt is currently rated BBB, or one to three notches above so-called junk, or sub-investment grade. Not surprisingly, the average yield on investment grade debt is sitting at about 4.4 percent, the highest level since 2010.

One giant canary in the debt mine

Last month, we also witnessed a strong warning from the markets, linked to the continuously rising degree of total leverage and financialization in the economy when the iconic giant of corporate America, GE, experienced a massive sell off on foot of its 3Q financial reporting. At the height of the 2002 to 2007 boom, GE grew to become one of the largest financial and industrial conglomerates in the U.S. history. Today, thanks to decades of mis-investment, financial engineering and debt-funded shares buy-backs, GE is fighting hard to generate positive cash flow. In 1994, GE had total liabilities of $158 billion against total equity of $28 billion. By the second quarter of 2008, these rose to $720 billion, with total equity at $127 billion. A decade later, following aggressive divesting of financial assets, in 3Q 2018, GE had total liabilities of $263 billion with total equity at $48 billion. Put differently, GE’s leverage ratios remained stubborn within 5.5-5.7 range for a good part of two and a half decades, despite a decade-long period of aggressive deleveraging and divestments. Between 2015 and 2017, GE has bought back some $40 billion worth of its own shares, with repurchases taking place at prices of $20 to $32 per share. With GE currently trading at $7.50 a share, the buybacks cost shareholders some $30 billion in value, or nearly four times more money, than the company generated in corporate income.

As an indicator of forward risks, this story is an ominous one. Over the next three years, some 70 percent of currently outstanding corporate debt in the investment grade markets will require roll-over. Increasing scrutiny by the markets of heavily leveraged firms, like GE, if aligned with rising interest rates, can result in investors switching from risk aversion behavior to loss aversion. This can put a hard stop to liquidity supply in corporate assets markets, triggering another financial crisis on par with, if not worse than, the one in 2008.

Debt trap signals a bust

On a macroeconomic scale of things, much of the U.S. corporate sector is an equivalent of Belgium – a country that has been forced to swim harder and harder to stay put in the torrent of debt accumulated back in the early-1980s through the mid-1990s. And this is only the beginning of the underlying leverage risk assessment for the U.S. and the global economy.

Research by the Bank for International Settlements and the IMF shows that across 25 advanced economies, historically, credit booms accompanied by deteriorating credit quality have been followed by three to four years of growth slowing down by 2 percentage point on average. Current debt cycle, in magnitude, suggests a medium-term slowdown of 3 to 4 percentage points, effectively implying a sizeable recession.

And the problem is not restricted to the advanced economies. As the chart below shows, emerging markets are rapidly catching up with the developed economies in terms of real economic debt build up. The chart below shows the dramatic increase in global leverage since the global financial crisis, compared to the decade prior to 2008. See figure 1

Figure 1: Real Economic Debt: USD trillions and Percent of GDP
Source: IMF, October 2018. Data through 2017, with 2018 forecasts by the author based on 2Q 2018 annualized figures.

This emerging market debt is predominantly denominated in foreign currencies, with pricing linked to the U.S. dollar. This means that the recent strengthening of the U.S. currency is putting severe pressure on corporate borrowers independent of the underlying interest rates changes.

In her G20 comments, Christine Lagarde noted that diffusing the real economic ticking time bomb of debt should be an imperative for developed and emerging economies alike. Alas, after some two decades of loose monetary policies across the globe, the window for action is closing faster than the policy makers capacity to grasp the extent of the problem.