PROSPERING ON CRIME:
MONEY LAUNDERING AND FINANCIAL CRISES
Guilhem Fabre*
In 1998 , the
International Monetary Fund estimated that illicit funds, worldwide, amount to
between $800 billion and $2 trillion -- two to five per cent of the world’s
GDP.[1] These facts are no longer a great surprise.
Leading journals have recently published articles on the magnitude and
processes of money laundering.[2] The incredulity of
those who act as if they are just discovering corruption in emerging nations brings
to mind the police officer in
Casablanca who is shocked to find gambling in a casino. Instead of condemning such open secrets,
public officials ought to investigate how illicit profits are recycled into the
legal economy – the consequences of prospering on crime. What, for example, is the relationship among offshore companies
recycling “dirty money,” the Central Bank of Russia,
the Bank of New York, governments of developing countries and the vicissitudes
of international financial aid ? The answer is hardly self-evident. But an
increasing body of evidence suggests that there is a link between money
laundering and financial crises.
The post-Cold War financial system rests on
two assumptions that fracture one another.
The first is that free capital flows – like international trade --
optimize the allocation of global resources.
This assumption is dubious, both theoretically and empirically.[3] Although the massive
increase in direct foreign investments has contributed to economic development
in the South, the larger bank loans and other short-term financial have
produced the opposite effect, diverting investment from productive sectors to
areas of potentially rapid capital appreciation, such as highly speculative
stock markets and real estate.[4] This damages the export competitiveness of
developing countries, the supposed basis for repaying foreign loans. Moreover, increasingly frequent recourse to
foreign loans for the purpose of financing public debt (supposedly to reduce
the risk of inflation) aggravated the risk of currency crises and default on
loans in Mexico, Russia and Turkey.
The second assumption is that the legal and
institutional infrastructure that enabled free financial flows between North
American, Europe and Japan were of secondary importance.
In the post-Cold-War euphoria, decision-makers accepted uncritically the
idea of a self-regulating market. They
underestimated the importance of legal standards that were instrumental to the
development of the capitalist economy over the last two centuries as well as
the significant burden imposed by the lack of such institutions in transitional
economies. The co-existence of free
international capital flows and national institutional and regulatory systems
created a void in which transnational economic and financial delinquency
flourished.[5] Transitional economies privatized state-owned
firms without allowing market competition or creating necessary institutional
and legal infrastructure for effective markets.
Tax evasion accounts for the most important share of crime; however,
other problems include capital flight in countries where exchange controls are
inadequate, counterfeiting (which represents, according to the OECD, 6 percent
of world commerce), insurance fraud, and contraband. Thus, corruption grows with new opportunities
in North-South exchange, and in the legal void of countries in transition,
which, while instituting privatization policies, accept the market economy’s
idea of profit but not the complementary ideal of market competition.
The
Growth of “Grey” and “Black” Markets
The sizeable development of the “gray
economy” in the context of finance-driven globalization favored the spectacular
expansion of offshore markets and tax havens through which nearly half of the
world money supply is currently funneled.
In 1979, there existed only 75 offshore funds. Today, they number more than 3,000. These havens institutionalize tax evasion,
especially by the world’s great fortunes—a third of whose holdings, estimated
at $5.5 trillion (or 18% of the world’s GDP) are placed in offshore funds[6]. Sheltered from central bank supervision,
these new extra-territorial spaces are the home of choice for hedge funds that
manage some two-thirds of their assets from tax havens.[7] Even
though all hedge funds combined amount only to some $300 to $400 billion --
rather little compared with the $26 trillion of the major financial
institutions (insurance firms, pension funds, banks) - they have privileged access to credit, and
this multiplies risks to the financial system.
In the fall of 1998, the last-minute rescue of Long Term Credit
Management (LTCM), a Wall Street darling located in Connecticut, but officially
headquartered in the Cayman Islands,[8] proved to the world
that a single institution with assets of less than $5 billion could threaten
the entire financial system by taking positions in excess of $200 billion,
thanks to the credit received from major banks and brokerages.[9]
Globalization has been accompanied not only
by the growth of the gray economy but that of a black economy as well.
According to the UN, organized and unorganized crime now generates annual sales
on the order of 3% of the world’s GDP, about $1 trillion, half of which is in
drug sales, which have boomed over the last decade, stimulated by an abundant
supply and diversification into synthetic narcotics[10].
Other profits from crime are drawn from multi-service activities such as the
control of legal and illicit gambling establishments, the arms trade, human
smuggling, traffic in body organs, car theft,
prostitution and racketeering. These
profits boost demand for money laundering, which favors offshore markets
because of their secrecy and immunity from legal oversight.
In
response to the demand for money laundering services tax havens and offshore
markets have developed into international hubs for three kinds of illegal
legality: 1) the white economy of banks, investors, and fund managers; 2) the
grey economy of tax evasion and corruption; and 3) the profits that organized
crime seeks to recycle. The boundaries among these three domains are nebulous since
the illegal activity occurs prior to transfer of funds to offshore
markets. In addition, it is usually
impossible to distinguish between tax evasion and profits from crime because
the recycling techniques are identical[11].
The
Functions of Money Laundering
Beyond
the evasion of legal regulation, offshore markets in the post-Cold War period are
all the more threatening because money laundering has played a significant role
in (post-Cold War) the financial crises of nation states. The experience in
Russia,
recorded in abundant detail through a sequence of scandals closely tied to
political back stabbing,
suggests that there are intricate links among capital flight,
embezzlement, racketeering, pillaging of public assets, corruption and
organized crime. As I have demonstrated in a recent study, significant profits
derived from organized crime and corruption, were deposited in Swiss banks
and re-invested in Russia to finance the growing national debt[12].
Corruption and criminal activities played a major part in creating public debt
and diverting funds to speculative overseas financial markets
: the Russian Central Bank estimated that $ 74 billion was transferred
from Russian banks to offshore accounts in 1998, the year of the devaluation[13]. A predatory, kleptocratic,
and, in the end, Mafia-style pattern of abuse created substantial demand for
money laundering on international capital markets, including the demand for
Russian Treasury bonds, and was an important factor in the Russian financial
crisis of 1998.
There
are other examples, as well, which are typically overlooked in neoclassical economic
analyses that remain limited to empirical testing of limited models. Yet such examples
reveal the sometimes incestuous relations between the laundering of “funny money”
and financial crisis.. The Mexican crisis of
1994-1995, and the “tequila effect”,
or the repercussions which it triggered in Latin American countries
through the regionalisation of exchanges , can only be
understood if the “cocaine effect” is also taken into account. Starting in the
1990’s, Mexican drug dealers took charge of one half of the Colombian drug
trade to the United
States, and thereby repatriated
some 3 to 8 billions dollars per year, which exceeded the value of Mexico’s
oil exports[14]. Part of these funds went
to the ostentatious consumption of luxury goods from the
United States, thereby increasing the country’s dependence on imports. The rest
was recycled in small businesses, luxury real estate, and the securities and
grey currency markets, which levy some 10 to 15 percent for their money
laundering services. The hasty privatization initiated by Carlos Salinas also
provided opportunities for recycling narco-profits,
especially in the banking sector where the State sold a series of firms for $12
billion. After the crisis, these banks were saddled with debts in excess of $60
billion, which were subsequently assumed by the State.
In
Mexico, money laundering was combined with international short-term
capital flows to create excess liquidity and a stock market and real estate
bubble. Though at the outset they corresponded to only 1 to 3 percent of GDP,
the mass of narco-dollars managed to distort
competition to the advantage of organized crime in small business and banking. The
“laundering premium” which they earned made it possible for them to be more
competitive and on occasion to absorb their competitors, while emphasising short-term speculative investments. Moreover,
their access to credit made it possible to recycle and expand
capital of dubious origin. Far
from improving the general competitiveness of the export economy, or helping to
reduce external debt, laundering accentuated imports of consumer goods and
emptied the productive sphere in favor of short-term investments. The injection
of narco-dollars thus contributed to the
deterioration of foreign trade and precipitated payment(s) defaults,
devaluation and the financial crisis of 1994-1995.
As
in Russia and Mexico, the Thai crisis, which triggered the Asian crisis of 1997, is no
stranger to money laundering. According
to a study published in 1997 by three researchers at
Chulalongkorn University,[15] the equivalent of 8
to 11% of the Thai GDP was controlled, at the onset of the crisis, by organized
crime, which derived its profits mostly from gambling and prostitution, and
also from drug traffic out of Burma.
Accelerated
democratization of the Thai political system during the 1990s gave a clear
advantage to the provinces rather than the
Bangkok
region. Bangkok was the
stronghold of the modernist democratic party and generated half the GDP. The peripheral regions were under the control
of local “godfathers,” frequently of Sino-Thai origins, who combined certain
legal monopolies with illegal activities such as gambling, prostitution, drug
trafficking, and contraband in wood and precious stones. When the provinces
acquired the decisive role in fragile government coalitions, political
patronage encouraged money laundering. Once again, it focused on speculative
real estate and stock market investments, in a context of insider trading
scandals that occurred in the course of privatization.
As
in Mexico, the inflow of foreign short-term capital, most often transited
through the Bangkok Offshore Banking Facility, accelerated local speculation by
limiting investments at the expense of the productive and export sectors. The
deterioration of the external accounts that ensued was aggravated by the rise
of the dollar and the slowdown on the electronics export markets in 1996.[16] This precipitated the
exchange crisis and the devaluation of the baht. But the pressure created by short-term
investments or by the results and figures in the formal economy does not
explain the magnitude of the crisis. The
local political and financial system also played a part, in that it strongly
favored the laundering of profits from crime.
By the end of 1999, two years after the crisis, whereas the Thai GDP had
contracted by 10% in 1998 alone, and the surplus on the real estate market was
estimated at 300,000 units in the
Bangkok region, real estate prices did not fall.[17] This stability remains incomprehensible if
one analyzes real estate prices according to traditional market criteria, but
the puzzle disappears when one factors in the need for money launderers to
funnel massive amounts of funds into real estate, as well as the delays which
they caused in the reconstruction of the financial sector.
Japan :
The Yakuza Recession
The
role of money laundering is also evident in developed economies, e.g. in
Japan,
the world’s second largest economy. To understand the yakusa’s
social legitimacy, Curtis Milhaupt and Mark West have
shown that “in Japan, the activities of organized criminal firms closely track
inefficiencies in formal legal structures, including both inefficient
substantive laws and a state-induced shortage of legal professionals and other
rights-enforcement agents.”[18] The role that the yakuzas played in the speculative bubble of the 1980s is
now known.[19] Through their control
of drug traffic, prostitution, employment in the building sector, and public
works, as well as a
part of the very lucrative business of pachinkos—those
electric billiard games which generate one and a half times the turnover of the
Japanese automobile sector (some 6% of the GDP)—organized crime has invaded the
real estate co-operatives (jusen), the leading
brokerages and the shareholders’ meetings of certain large companies[20]. Their access to
credit enables them to launder their illicit profits in speculative businesses,
where they tend to prefer high-risk operations.
When the speculative bubble burst at the beginning of the 1990s, stock
and real estate prices dropped, and bad debts swamped the banks and other
financial institutions. The former
director of the National Police Agency, Raisuke Miyawaki, estimates that 10% of these debts are
yakuza-related and an additional 30% have probable links with organized crime,
which would put such non-recoverable debt attributable to gangsters at somewhere
between $75 and $300 billion, that is, 6.5 percent of GDP[21].
After
having speculated on the upside, the yakuzas then
speculated on the downside, trying to buy up real estate assets at fire sale
prices and by blocking, through targeted operations, the liquidation of the
liabilities of certain firms which resort to the yakuzas’
illegal services in order to escape their engagements. This explains why the fall in real prices of
real estate, between 30 to 70 percent since the beginning of the 1990s, did not
coincide with a corresponding rise in transactions, and thus retarded the
reconstruction of the financial sector, the supply of credit, and, in the end,
new growth. There are of course other
factors that explain Japan’s economic difficulties; however, the “yakuza recession,” in the
words of Raisuke Miyawaki,
should not be taken lightly. Despite the government’s numerous expansionist
policies, which increased the GDP by several percentage points, the exceptional
length of the Japanese crisis is fully understood only when one takes account
of money laundering and the activities of organized crime. These socialized the costs and privatized the
profits of organized crime, thereby distorting the competitive
environment. From 1985 to 1995, the
Japanese GDP grew by 52 percent while all financial assets grew by 85
percent. The difference between these
two figures demonstrates the persistence of the speculative bubble,[22] which centered in the
real estate market, the yakuzas’ sector of choice for
their invisible maneuvers, which delay market adjustment.
September
11th and Beyond
The
cases of Russia, Mexico, Thailand and Japan do not prove that there exists an automatic link between money
laundering and financial crises. The
argument would be strengthened by further research on other examples of
financial crises, such as those of Argentina,
Turkey and Nigeria in 2000-2001. But the accumulation of such crises and their
probable links to money laundering demonstrate how the forces that prosper from
crime – however marginal in comparison to the formal economy – can provoke
decisive political repercussions.
Although it is clear that the masses in the
Arab world have been subdued -- under humiliating conditions -- by Western
nations and by their own governments, the September 11th massacre does not
reflect an act of revenge to
this state of affairs. On the contrary, it illustrates, with
unprecedented drama, the political strength of criminal networks whose power,
in this case, stems from the systematic destruction of enlightenment Islam, and
the symbolic manipulation of a sect of wahabic
origin, supported by rent-seeking families of Saudi Arabia.[23] In this sense, the
sound and fury sparked by the war in
Afghanistan is a striking contrast to the veil of silence surrounding the
financial investigations into the speculative maneuvers in the U.S,
London, German,
French and Italian. stock
markets launched just days before the attack by apparent accomplices.[24] Yet political will
and political means must overtake this dual system, where the methods of
supervision and the rules of the game are at least a decade behind the rapidity
of financial flows and the existing capacities for circumvention. Without significant changes in the regulatory
superstructures of financial institutions worldwide, the links between those
who prosper from crime, money laundering and financial crises are likely to
proliferate, protected by the fear they inspire and the silence they maintain.
Copyright : Guilhem Fabre
guilhemfabre@noos.fr
*Professor of International Affairs,
Le Havre
University (France).
Author of Criminal Prosperity: Drug Trafficking, Money Laundering and Financial
Crisis after the Cold War, RoutledgeCurzon,
London and
New York, 2003.
Co-Director, UNESCO and
UNODCCP (United Nations Office for Drug Control and Crime Prevention) Joint
Program on the International Drug Problem.
Senior Research Associate, Ecole des Hautes Etudes en
Sciences Sociales (EHESS) China Centre, 54 Bd Raspail, 75006, Paris, France.