The crisis that began in late 2007, and which seems to be continuing for the foreseeable future, has highlighted the role of global wholesale financial markets in creating what may be described as new dependency relationships. Old dependency theory was a structural-Marxist theory. It hypothesised that the world capitalist economy is structurally arranged to facilitate massive transfers of capital from developing countries to the developed world. The new dependency theory agrees that net outflows of capital from developing countries have been continuing unabated for the past three decades. But—and this is a key difference between new and old dependency theory—these illicit flows are a problem not only for developing countries but also for developed ones.
This is so for two reasons. First, the net flow of capital is not necessarily transferred to or invested in the developed world. Rather, the transfer of financial resources from developing countries joins a large pool of capital registered in offshore locations. Second, there is evidence that developed countries are subject to net external outflow of capital as well. In contrast to old dependency theory, the new theory suggests that capital transfers do not necessarily operate on a regional or intra-national basis; rather, wholesale global financial markets have emerged as gigantic re-distributive machines that play a key role in the continuing and growing gap between rich and poor world-wide.
In developed countries, the main detrimental impacts of illicit flows are growing income inequalities and a weakening and narrowing of the tax base, as effective (as opposed to nominal) tax rates by corporations and rich individuals decreases continuously. For developing countries these problems are compounded further: they include poor governance structure, a large black economy, lack of capital for basic infrastructural projects, and over-reliance on foreign aid money that generates harmful political-economic dynamics. More fundamentally:
• Alternative sources of elite revenue made possible by illicit capital flows reduce the need for negotiated settlements between government and society, which lie at the heart of the development of the European democratic state model, and undermines the development of efficient and accountable state institutions
• Proximity of large offshore financial centres damages capacity for an endogenous financial system
These will be discussed further, below.
The Architecture of the Private International Banking Industry
By the 1970s large surpluses of capital from OPEC member states—the so-called 'Petrodollars'—were deposited in fledgling unregulated wholesale markets (known as the Euromarkets) that were rising to prominence as a result. Howard Wachtel (Wachtel 1977) calculates that, in the three years between 1973 and 1976, OPEC countries accumulated current account surpluses of about $158 billion. The vast majority of these so-called Petrodollars were deposited in U.S. based multinational banks—but crucially, not in the U.S. They joined, instead, the pool of capital that made up the offshore financial Euromarkets. Wachtel identified the rise of what were subsequently described as large complex financial institutions (LCFIs) at the heart of the Euromarkets' web of activities.
The first comprehensive analysis of the rise of the new phenomena of tax havens serving as offshore financial centres (OFCs) provided evidence to support Wachtel’s thesis. Park (1982; see also Choi, Park and Tschoegl, 1990) presented a picture of an increasingly integrated international wholesale financial market operating through various cities and islands—which began to be described as OFCs because they specialised in non-resident finance—spread around all the major commercial centres of the world. The unique non-territorial profile of the Euromarkets gave rise, he argued, to enormous economies of scale in finance by integrating different locales into one integrated global wholesale market. Many OFCs developed a profile as ‘funding’ and ‘collective centres’—regional facilities that either tap or fund Euromarket operations.
Two subsequent studies of OFCs furnished further evidence of the international integration of these wholesale markets. A 2001 report commissioned by the Bank of England demonstrated the importance of ‘financial intermediation undertaken by entities based in many OFCs [i.e. tax havens, that] is almost entirely "entrepôt"’. (Dixon 2001, 104) The report identified large flows of capital between these centres, back and forth, for reasons that were not entirely clear. Various strands of research into emerging global and offshore financial markets were then brought together in a comprehensive IMF study (Fund 2010) that examined the processes that have contributed to what it described as international financial interconnectedness. This pioneering study charted an emerging topology of global financial markets but, as befitting an international organization, refrained from speculating on the political or economic implications of this new financial architecture. The IMF's findings were as follows:
• ‘The architecture of cross-border finance is one of concentration and interconnections. Countries are exposed to certain key money centres or "nodes"—common lenders and borrowers—through which the majority of global finance is intermediated. These exposures reflect transactions that occur predominantly through a small, core set of large complex financial institutions (LCFIs).' These were the same institutions identified by Wachtel in his 1970s study.
• 'LCFIs are systemic players, measured by importance in global book running for bonds, structured finance, U.S. asset backed securities, syndicated loans, equities, and custody asset holders... They operate with global ALM strategies and are engaged, either directly or through affiliates, in banking, securities, and insurance operations.'
• LCFIs 'comprise banks as well as nonbank institutions, such as investment banks, money market funds, and structured investment vehicles (SIVs)... The nonbank entities are often linked to banks, including through credit and liquidity enhancement mechanisms, a behaviour that has been fuelled in part by the desire to avoid regulations.'
• Subsequent studies by the Federal Reserve of New York have named this shadowy world of complex entities linked to the LCFIs the 'shadow banking industry'. The IMF study shows that this shadow banking industry is larger than the official banking industry.
• The IMF study also showed that, as argued by Park in the 1980s, the infrastructure of payments and settlements in this integrated offshore wholesale market is 'highly concentrated, largely occurring over a few systems'.
Unregulated finance, capital flows and tax evasion
If the development of the global wholesale market in this way was not the result of deliberate planning (a point I return to below), it is nevertheless clear that its current design serves particular purposes and contributed to pathologies that are at the core of the current crisis. These pathologies include:
• vast amounts of capital deposited offshore by the rich and powerful to avoid taxation, skewing income and wealth distribution worldwide
• regulatory arbitrage and the development of shadow banking to escape existing financial regulations
• the emergence of the shadow banking industry to overcome structural limitations on financial industry growth, contributing to the artificial liquidity that was at the heart of the crisis. (Nesvetailova 2010)
I discuss here the first of these pathologies. It is ironic that one of the earliest versions of the new dependency theory was articulated in a book written largely as an apology for the Swiss banking industry. In The Gnomes of Zurich, Fehrenbach (1966) maintained that large capital flows to the secretive Swiss banking system added a layer of stability to an increasingly volatile financial system. Fehrenbach argued, in addition, that the big three Swiss banks (UBS, Credit Suisse, Swiss Bank Corporation) had together accumulated about $500 billion dollars in assets from third world countries by the 1960s, but that each had opted to re-invest those liabilities largely in the developed world. Fehrenbach argued, in effect, that the Swiss banking fraternity acted as a conduit for financial flows from developing to developed countries—challenging the conventional wisdom that less economically developed countries (LDCs) were net recipients of capital from the developed world.
During the 1980s and 1990s, considerable evidence was gathered on the deleterious impact of intra-trade transfer pricing techniques perpetrated by multinational corporations, particularly in the mining industries of the developing world. The first comprehensive assessment of global cross-border illicit money flows estimated them to be in the order of $1 to $1.6 trillion annually. (Baker 2005) About 70% of all capital flight was conducted by means of transfer pricing. Half of this, or $500 to $800 billion a year, flows out of developing countries to the large offshore financial centres.
The strongest evidence for the new dependency relationships is provided by a recent analysis of global private financial wealth registered in offshore locations. (Henri 2012) It estimates that at least $21 to $32 trillion of global financial assets—about 18% of all financial assets—was registered in offshore locations in 2010. It traces $9.3 trillion of offshore wealth belonging to residents of 139 mainly low- and middle-income countries. As it notes, these findings
‘underscore how misleading it is to regard countries as “debtors” only by looking at one side of the country balance sheet. Indeed, since the 1970s, with invaluable assistance from the international private banking industry, it appears that private elites in these key developing-world source countries have been able to accumulate at least $7.3 to $9.3 trillion of offshore wealth... compare with these same source-countries’ aggregate 2010 gross external debt of $4.08 trillion, and their aggregate net external debt—net of foreign reserves, most of which are invested in First World securities—of minus $2.8 trillion. In total, by way of the offshore system, these “source countries”—including all key developing countries—are net lenders to the tune of $10.1 to $13.1 trillion. By comparison, the real value of these source countries’ gross and net external debts—the most they ever borrowed abroad—peaked at $2.25 trillion and $1.43 trillion respectively in 1998, and has been declining ever since’. (Henri 2012, 4-5)
The combined transfer of financial assets from low- and middle- income countries to offshore accounts is equivalent to nearly 10 times the annual GDP of the entire African continent. Put differently, for every dollar poor countries have received in development assistance, more than twelve dollars are illegally transferred out to offshore accounts.
Impact of the New Dependency on Developing Countries
What is the impact of large net transfer of capital from low- and middle-income countries to offshore locations? The typical developmental model of the developed economies of the OECD is founded on the principles of ‘a relatively stable compromise between capital and labour mediated by electoral democracy, high public spending and near-continuous economic growth’. (Moore 2013, 19) Many developing countries, in contrast, suffer from failing or absent market mechanisms, widespread corruption and a large black economy. All of these are facilitated by the ease with which money can be illicitly funnelled into the offshore financial system.
Moreover, recent literature has demonstrated empirically and theoretically that a properly run tax system is an essential component of any developmental strategy. Tax revenues are needed not only to fund the developing state, but also in order to establish bargaining relationships between governments and their citizens and build long-term institutional capacity, both of which are at the heart of the OECD state model. (Bräutigam, Fjeldstad, and Moore 2008) The net flow of capital exposed by the new dependency theorists makes it much easier to evade taxation and thus reduces the tax base of developing countries.
Offshore financial flows also enable political elites to amass illicit revenue sources As Mick Moore argues in a seminal article, tax havens enable
‘those who command what I have termed "elite political revenues" to hide these incomes and/or launder them into what appear like someone’s legitimate business profits... [and] facilitate and stimulate corruption, drug trafficking, diamond wars, piracy, and the theft of natural resource revenues’. (Moore 2013, 24)
This also has the effect of freeing political elites from dependence on taxation, which thereby encourages the development of authoritarian and institutionally fragile states. There is thus a clear link between illicit financial flows and aid dependency, weak infrastructure, failed models of government and poverty.
The Owl of the Minerva Flies at Dusk
Progressive academics have tended to understand the development of the offshore financial market in terms of Wall Street domination or American ‘imperialism’. But the historical evidence suggests that the U.S. Treasury—as opposed to the Wall Street fraternity—resisted its emergence between the early 1960s and the late 1970s, to no avail. Indeed, if any one polity played an important role in the emergence of the new financial architecture, it was not the American state but the British Empire. Attempts to explain its development in terms of class or national interest are also problematic. Until very recently the offshore was not even superficially understood, let alone consciously designed.
Here lie the key philosophical and conceptual differences between the two dependency theories. Whereas old dependency theory was Marxist in presentation, but nationalist in orientation, seeking to combine a theory of class struggle with a nationalist ‘third worldist’ ideology, the new dependency theory is institutionalist in its analysis and political orientation. It does not assume a necessary link between outcome and intent. National and business leaders, bankers and financiers do not necessarily understand, still less control, events. In the years leading up to the 2007 crisis many of them did not understand the practices and behaviour of their own organisations (and this was particularly true of large multinational banks), and were as mystified as the rest of us about the sources of their fabulous profits. But, like the majority of the population, they were happy to support the system as long as it seemed to work for them.
A full analysis of the origins and method of construction of the new dependency theory remains to be written, but anecdotal evidence suggests that its initial theorists understood the emergence of global offshore markets in terms of the aggregate outcome of local decision-making processes that, together, contributed to institutional change. No doubt each of these local decisions was driven by the profit motive, but the aggregate outcome was neither intended nor foreseen.
This design feature is, in my view, a cause for cautious optimism. My own experience with tax havens has taught me that focused, informed and politically savvy activist networks like the Tax Justice Network can achieve a lot. The owl of Minerva flies only at dusk, wrote Hegel. It is now, when the new dependency relationships are beginning to be understood, that they are at their most vulnerable politically. I note, for instance, that some of the most critical and detailed research into the new architecture of global finance has been conducted by the research arms of organisations that are often associated, at least in progressive circles, with Western imperialism: the work of Poszar and colleagues at the Federal Reserve Bank of New York and now the U.S. Treasury, Andrew Haldane and colleagues at the Bank of England, Claudio Borio and colleagues at the BIS, and indeed the various departments of the IMF that produced the report cited above. I would not wish to underestimate the vested interests that gained enormously from the new dependency relationships and the offshore system which has made them possible. But, as many of these interests cut the very branch of the tree on which they stood, widespread concern with financial stability and economic growth can be marshalled to build support for reforming the global financial system in ways that will undermine the new dependency relationships.
Ronen Palan is Professor of International Political Economy at City University London and co-author of Tax Havens: How Globalisation Really Works.
This article is part of NLP's series, Left Politics in an International Economy.
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