The Finance Curse: How Oversized Financial Sectors Attack Democracy and Corrupt Economics
By Nicholas Shaxson, John Christensen
Over the last decade, the attitude took hold that what was good for Wall Street was good for the country… a whole generation of policy makers has been mesmerized. Simon Johnson, former IMF Research Director, 2009
Beyond a certain point, financial development is bad for an economy. Instead of supplying the oxygen that the real economy needs for healthy growth, it sucks the air out of the system and starts to slowly suffocate it.
Stephen Cecchetti, author of a Bank for International Settlements study on the issue, 2012 *
Despite the trillions flowing into and through the City of London, for instance, Britain performs worse on major human development indicators – inequality, infant mortality, poverty, and more – than Germany, Sweden, Canada and most of its other rich-country peers. Each ailment has many explanations, but oversized finance appears to be a major contributor.
The Finance Curse is a story about “Country Capture” - where an oversized financial sector comes to control the politics of a finance-dependent country and to dominate and hollow out its economy.
The tax havens, which we have studied extensively, carry important lessons - and warnings - for larger finance-dependent countries.
A sector widely regarded as the Goose that Lays the Golden Eggs often turns out to be a very different bird: a Cuckoo in the Nest, crowding out, hollowing out and undermining other economic sectors. Very often, the interests of the financial centre conflict directly with the national interest.
If too much finance is harmful, then it makes clear political and economic sense to regulate and tax this sector appropriately.
If too much finance is harmful, then it makes clear political and economic sense to regulate and tax this sector appropriately.
This is not a book about how global financial centres can transmit damage to other countries, important though that subject is. It is about how an over-sized financial sector can harm its own host country.
For decades many people considered it self-evident that expansion in a country’s financial sector broadly benefits the local economy. This assumption is intuitively so attractive that many still believe it, despite all that has happened in the recent global financial crisis.
Yet evidence is accumulating that above a certain size, financial sector growth fails to deliver expected benefits to a country, and can even harm it.
The Finance Curse is a complex, multi-layered set of phenomena bound together into a phenomenon that we call ‘Country Capture.’ *
Country Capture can be summarised simply:
Country Capture = Economic Capture + Political Capture.
The political and economic processes involved in Country Capture reinforce each other in feedback loops. For example, political capture ensures that state resources are increasingly directed towards supporting the ‘easy’ dominant sector, at the expense of more ‘difficult’ alternative sectors, reinforcing economic capture. Meanwhile, damage caused to non-financial sectors increases the political weight and influence of finance.
A financial focus on rent-seeking displaces genuine productive and entrepreneurial activity, further weakening alternative sectors; at the same time easy economic rents from finance weakens government officials’ incentives to create a conducive environment for alternative sectors to flourish.
Effective policies can counter this Country Capture. But Country Capture will make it much harder to find the political will to put such policies in place. *
The core thesis of this book is not that finance is bad per se, but that above a certain level, financial sector growth can be harmful. Certainly, the financial sector seems to have massively outgrown its ‘utility’ role servicing the domestic (and, at times international) productive economy.
Experience and research shows that large wealth accruing to the top echelons of society, notably from the financial sector, are accompanied by economic stagnation for the (much larger) middle and poorer sections.
Most of the claims for finance made in Section 2.3 above are fatally flawed by two big factors:
- The Net versus Gross problem Here lies one of the great misconceptions about the ‘contribution’ of finance: the taxes raised, the jobs created, and so on.
The lobbyists invariably provide gross numbers for this - but it makes no sense for policy makers to pay any attention to gross numbers: it is always the net figures they should consider. Once one takes into account the bailouts, the crowding-out, the loss of entrepreneurialism, the financial instability, and many other harmful impacts from oversized finance - the net number will be far smaller and may well be negative. This book argues that in Britain’s case, it is strongly negative.
In addition, an even bigger factor in the net/gross calculation is that oversized financial sectors tend to crowd out other sectors. So if a country’s financial sector were to be smaller, most people currently employed in finance would have found productive employment elsewhere: these highly-paid financial sector players tend to be the country’s brightest and best educated citizens. It seems likely that in many cases oversized finance has reduced net employment, tax and so on in the long term.
- Mobile and immobile finance: what will move? The central threat repeatedly made by financiers to justify less financial regulation or lower taxation goes along the lines of “don't tax or regulate us too much or your financial centre will become less ‘competitive’ and we will relocate to Zurich or London or Hong Kong.” But every time policy makers and regulators hear this threat they must remember: the financial centre is composed roughly of two parts. First is the immobile part, which is rooted in the local economy and cannot and will not leave in response to stronger financial regulation. The second is the flightier mobile part, which could potentially be prone to departure. So when policy makers and regulators worry about the ‘competitiveness’ of the local financial centre they must consider only the mobile part that is potentially at risk of relocation, and disregard the locally-rooted immobile part. For the purposes of policy making, these must be regarded as separate sectors.
The question then becomes: how much of the financial sector is mobile? This is speculative, but data from the United Kingdom provides one useful benchmark. TheCityUK estimated that UK financial services contributed £63 billion in tax revenue in the 2011/12 financial year, and that of this £63bn “£20bn is mobile and could move from the UK.” So we calculate that if financial regulators and other policy makers are worried about the ‘competitiveness’ of the financial sector, then for policy purposes they must consider only 20/63, or about 32 percent of the published numbers for the City of London’s gross contribution. This ratio can be applied not just to figures for the tax contribution, but also to other figures such as employment.
This 32 percent share is obviously a very rough rule of thumb but it is a far better approximation than the 100 percent figure TheCityUK would like us to take on board. What is more, this share should be considered an extreme upper limit, for several reasons.
First, TheCityUK and the City of London Corporation which collaborate to put together this data are official lobbying organisations whose standard modus operandi is to frighten impressionable politicians and journalists about the “competitive” threat that financial regulation might pose to local jobs and so on. So the £20 billion figure, which TheCityUK stated without providing any identifiable methodology, is likely to have been inflated to maximise the potential for scaremongering.
Second, other pointers suggest strongly that the 32 percent scale-down factor for the UK may be far too generous to the City of London: a figure of 20 percent may more justified.
Third, contrary to received wisdom, even if financial institutions based in the UK do shift substantial activity overseas, much of this will be retained in the U.K. tax net because of so-called Controlled Foreign Company (CFC) rules and capital adequacy rules, which make it hard to shift a lot of profits overseas for tax purposes. Furthermore, talk is cheap and there is enormous evidence that financiers’ threats to relocate abroad if taxes are raised or regulation tightened are almost never carried out when their bluff is called. Even so, we will take a cautious view and use this 32 percent extreme upper limit as the basis for our calculations for the UK.
To summarise: for the purposes of debate, analysis and policy making, the mobile and the immobile sectors must be considered as separate sectors. To make a political case for the local benefits of a financial sector being ‘competitive’ internationally, one must strip out all the data from the locally focused, relatively immobile ‘utility’ sector, and consider only the local benefits that flow from the potentially mobile sector. But these will still be gross numbers: from these scaled-down numbers, we can then subtract other costs to reach a net ‘contribution.’
A note on ‘casino’ and ‘utility’
The mobile/immobile distinction is similar to another rough analytical distinction that is commonly made in finance: between the ‘utility’ sector (the essential financial plumbing of an economy: offering ATM services, taking deposits, cashing cheques, financing local businesses and so on), and the ‘casino’ sector (the banks’ speculative proprietary trading side that has been heavily implicated in the wake of the global financial and economic crisis).
The utility is generally rooted in the local economy and is therefore immobile, while the casino is involved in both the mobile and the immobile sectors. The overlap here is certainly not at all exact, but it is a reasonable approximation. We suggest that a financial centre becomes oversized and the Finance Curse starts to afflict a country once the financial centre outgrows its utility role and expands into the casino sector. (This is not proven, but it fits all the evidence.) So higher capital requirements or other essential financial regulation will not put the more useful ‘utility’ parts of the sector at any ‘competitive’ risk: only the more harmful ‘casino’ parts will be in play. In short, appropriate tax and regulation will not only make the financial system safer - it will make the entire local economy more competitive too.
The City of London/TheCityUK and PWC show an apparently magnificent ‘total tax contribution’ of the financial sector, at £376.6bn for the six years to April 2012, or an annual average £62.8bn.
There are various different measures that can be used to calculate the tax contribution.
Using the same scale-down factor * would then yield a total corporation tax yield for the relevant mobile sector – £2.7 billion annually on average.
TheCityUK assets that the financial sector has created over 2 million jobs in the UK, this is over-inflated for several reasons.
This book argues that the rise of the City of London was a significant (though by no means the only) factor behind the dramatic crowding-out of and decline in British manufacturing, from employing 6.8 million people when Margaret Thatcher came to power in 1979, to 2.5 million in 2010 national statistics around the world routinely overstate the contribution of the financial sector to GDP growth.
In summary, the enormous imbalance created by a finance-heavy southeast of England has, via national-level pay bargaining, further damaged regional economies, magnifying the effect of a finance sector already sucking the best talent down to London.
Larry Elliott provides an example, in the Guardian: “The £15bn invested in Crossrail [a London-based rail project] dwarfs spending on infrastructure in the north. Indeed, the £322m earmarked for new rail lines to boost the big northern cities is exceeded by the £350m to lengthen two platforms at Waterloo station.
Generally, the claims made for the ‘efficiency’ of large financial sectors, and for the ‘efficiency’ of financial deregulation, rest on another fallacy.
The expansion of finance consumes scarce resources (such as the country’s brighest, best educated people) that could be deployed productively elsewhere.
So the gross ‘contributions’ of finance are often massively overstated. The next section shows why.
The net contribution is, in many jurisdictions, likely to be negative: a far more serious matter that constitutes strong support for the Finance Curse thesis.
Banks actively and often aggressively assist other corporations to escape tax. Consider these words from Dave Hartnett, head of the UK’s HM Revenue and Customs Service, in February 2009: “The banks have three roles. They provide schemes for tax avoidance for others; they use avoidance themselves and they fund schemes.”
Some scholars, analysing financialisation over several centuries, have suggested that a ‘financialised’ phase of capitalism represents the final phase of a nation’s power, heralding ultimate weakness.
In modern times, the financialisation of the U.S. and U.K. economies has been accompanied by tepid economic growth, soaring inequality and stagnant middle class incomes, and this book suggests a high degree of causation behind this correlation.
In the UK, the Joseph Rowntree Foundation found that 13 million people (or one in five) live below the poverty line , and of the 27 EU countries, only six have a higher poverty rate; Britain also reportedly has “the worst social mobility in the Western world.”
Under fierce public pressure for “something to be done” about the financial calamity, two reports were commissioned. One was commissioned by Boris Johnson, the Mayor of London, to produce a report on the City of London’s post-financial future. It was produced by a group led by Bob Wigley, the European chair of Merrill Lynch, and it included John Varley, the chief executive of Barclays, and Lord Levene, the chairman of Lloyd's of London. The second was co-chaired by Alastair Darling, UK Chancellor of the Exchequer and by Win Bischoff, the former chairman of Citigroup. This post-crisis moment was probably Britain’s one great chance for fundamental reform. The two reports, predictably, warned about the dangers of London losing its global ‘competitiveness’ as a financial centre, and used this as an excuse for what could broadly be described as inaction, or a preservation of the status quo. In fact, this was explicit in their very terms of reference: the Bischoff report was tasked “to examine medium to long term challenges to London’s continued competitiveness in international financial markets,” while the Wigley report was a ‘review of the competitiveness of London’s financial centre.” These facts in themselves highlight that the reports, which in the public mind were supposed to chart a new, democratically chosen and better way forwards for the City of London, were effectively presenting the public with a fait accompli.
The membership of those inquires contained no non-financial businesses and their trade associations; no trade unions (despite the unionization of retail finance workers); no NGOs to represent consumers or press social justice agendas; no mainstream economists or heterodox intellectuals; and very few politicians or civil servants.
The economic losses that arise from financial secrecy are unquantifiable, but undoubtedly very large indeed. The Tax Justice Network estimated in 2012 that upwards of US$21 trillion in financial assets lie shrouded in offshore secrecy, worldwide, though its author James Henry concedes that measurement is ‘an exercise in night vision’ due to measurement difficulties.
Few would dispute that there has been a substantial criminalisation of finance.
Recent examples that have surfaced just in the last year include the Libor and
Euribor scandals; insurance fraud (euphemistically known as ‘mis-selling’)
scandals, vast unpunished money laundering scandals involving HSBC,
Standard Chartered Bank, ING, Lloyds TSB, Credit Suisse, ABN Amro / RBS, and
Barclays – plus, of course, numerous others involving the facilitation of
tax, widespread mortgage fraud ahead of and in the wake of the financial
crisis. As Charles Ferguson of the acclaimed film Inside Job summarises:
Since the 1980s much of the global financial sector has become criminalised, creating an industry culture that tolerates or even encourages systematic fraud. . . . none of this conduct has been punished in any significant way.
In evidence submitted to the UK Commission on Banking, Rowan Bosworth-Davies, a former British financial detective, explores the criminalisation of the UK financial sector. His evidence contains the following: The British banking sector has become an organised criminal enterprise which has been allowed to develop because of the criminogenic environment in which it functions, which has resulted from the absence of any meaningful regulation which those who control and manage the banks would fear.
A senior central banker recently said that the City of London is now considered to be ‘the money laundering capital of the world.’
Bosworth-Davies also cites personal experience as a financial detective:
My squad got into real trouble for going round the DTI [Department for Trade and Industry].
During my career, even when I could demonstrate that my squad was dealing with named US mafia organised criminals who were setting up share dealing operations in London, DTI officials refused to do anything about it, and just laughed at us, accusing us of ‘seeing the mafia behind every bush.’
Even if unquantifiable, the costs of this ‘criminalisation’ are undoubtedly very large. As the US economist George A. Akerlof put it, in a version of Gresham’s Law: [D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.
It is not unreasonable to suggest that the damage caused by a country’s ‘capture’ by criminalised and corrupted financial élites, while immeasurable, might easily rival the harm caused by the death of alternative economic sectors, or of the apparently growth-killing effects of oversized finance.
As with the Resource Curse, the most important and the most complex root causes of the varied adverse outcomes concern the effect on political institutions and governance, which some believe to be the most important determinants of an economy’s success.
The City of London is fed by a large network of tax havens spread around the world, the remnants of the British Empire.
Much, though by no means all, of the City’s financing involves tax-evading and criminal funds from around the world.
The needs of finance must be protected from domestic challenge. The host jurisdiction must be trusted not to tax or regulate capital too sternly. *
If local democratic politics threatens the privileges of finance, then two possibilities emerge: either financial players and capital will flee elsewhere, or the governing classes must neutralise that particular aspect of democratic politics, to reassure the financiers.
If money is to be free, some citizens may have to be jailed.
It is important not to let the messy, noisy compromises of democracy get in the way of finance.
So in this particular respect the Finance Curse is in a way more dangerous than the Resource Curse, because it requires financial actors to take deliberate and sustained steps to neutralise democracy and undercut potential democratic challenges to finance.
Financial centres ‘compete’ with each other to provide the next best secrecy facility or loophole in order to attract tax-evading and other law-breaking forms of capital, producing a ‘race to the bottom’ on secrecy that has helped private élites escape taxation and the wider rule of law. This race undermines democracy and the rule of law and boosts corruption and criminalisation, on a global systemic basis - and the involvement of local professionals in this harmful global game rebounds on the host nation.
Many arguments in defence of finance rest on an assertion that it is essential to be ‘competitive’ in the areas of tax, financial regulation, and even criminal enforcement.
Wall Street and the City of London exist as fortress-like ‘islands’ of technical expertise inside their respective mother countries, equipped with massive financial and intellectual power, and sources of patronage. The technical complexity (both real and invented) of banking and associated professions creates opportunities to exclude outsiders and develop tight communities of interest, in which relatively small numbers of people can define a political consensus through highly sophisticated means: appeals to authority, more or less subtle cooption, threats and threatening innuendo to unruly insiders and rewards to journalists and politicians, and so on.
The tried and tested way of building a big financial centre is to engage in a “competitive” race to the bottom on financial regulation, tax loopholes, secrecy and other unproductive factors. This race is not only ultimately self-defeating (as others join in to undercut and outdo these facilities) and inflicts harm on the populations of other jurisdictions, but it is potentially a recipe for systemic global problems resulting from soaring inequality, higher debt levels and greater financial instability.
There is strong evidence that above a certain size relative to the local economy, growth in a financial sector harms the country that hosts it…