Recent news from Russia confirms that corruption is a serious issue that, unless curbed, can prevent the country from emerging as a global economic powerhouse. Corruption in Russia has been a hangover from the Soviet Union days. It is just that the forces of globalization have provided old hands and the up-and-coming younger generation of Russians with unprecedented opportunities to make money under the table. Of course, the exponential increase in Russia’s natural resource exports (such as petroleum products and natural gas) has not helped matters as far as overall governance is concerned. There is simply too much money in the hands of the too few.
This morning, Larry Summers, former U.S. Treasury Secretary under President Clinton and former top economic advisor to President Obama, wrote that European austerity is holding back economic growth, which is making their sovereign debt problem worse, both in individual countries passing austerity budgets and on a continent-wide basis.
One of the main problems underlying the current crisis in the Eurozone is that the conditions set out in the Maastricht Treaty which lay the economic foundation of the zone are not congruent with the criteria needed to form an optimum currency area. The criteria under the Maastricht Treaty namely are (i) a rate of inflation no more than 1.5 percentage points higher than the average of three EU members with the lowest inflation rates (ii) a ratio of the annual government deficit to GDP not to exceed 3% at the end of the preceding fiscal year or at least required to reach a level close to 3% with exceptional and temporary excesses granted for exceptional cases (iii) a ratio of gross government debt to GDP not to exceed 60% at the end of the preceding fiscal year (iv) that the member should have joined the exchange rate mechanism under the European Monetary System (EMS) for two consecutive years and should not have devalued its currency during the period and (v) that the long-term interest rate must not be more than 2 percentage points higher than in the three lowest inflation member states.
As Robert Mundell, the famous economist, spelt out, the conditions for an optimum currency area to be viable are that (i) the group of countries should not be hit by shocks that are too asymmetric in that one country should not be substantially worse off while others are booming (ii) there is a high degree of labor and/or wage flexibility within the group of countries and (iii) there is coordinated fiscal policy ensuring that capital is transferred from countries that are doing well to countries that are doing poorly. Members of the Eurozone do not meet most of these criteria.
Recent news from Russia confirms that corruption is a serious issue that, unless curbed, can prevent the country from emerging as a global economic powerhouse. Corruption in Russia has been a hangover from the Soviet Union days. It is just that the forces of globalization have provided old hands and the up-and-coming younger generation of Russians with unprecedented opportunities to make money under the table. Of course, the exponential increase in Russia’s natural resource exports (such as petroleum products and natural gas) has not helped matters as far as overall governance is concerned. There is simply too much money in the hands of the too few.
The history of advanced nations shows that, while each had to find its own way to fight this scourge of illicit capital, the rule of law has always been essential in efforts to raise living standards. In contrast, significant weaknesses in overall legal, institutional, corporate and political governance in many emerging market countries is posing an increasingly serious challenge for governments to meet the aspirations of the poor for a better life.
Illicit financial inflows and illicit financial outflows must be added together in order to accurately measure the adverse impact of these flows on developing economies, explains Dr. Dev Kar.
Global Financial Integrity Lead Economist Dev Kar examines the role of illicit financial flows (IFFs) in the Greek debt crisis. IFFs cost Greece an estimated US$160 billion over the last decade.
Greece has been in the news a lot lately and as we all know, it has not been good news. By all accounts, the austerity measures being imposed on the population as a condition for bailing Greece out of the financial crisis, is severe. As Walter Mead points out in a recent blog, investors are worried that the Greeks may not stand for them. He rightly notes that ordinary Greeks feel that the rich should pay the costs of the economic crisis and not them. They are right. According to an article in the Washington Post (Is austerity a Greek myth? By David Ignatius, May 3, 2010), Prime Minister Papandreou admits that corruption now robs the Greek economy by US$20-30 billion and “graft” (probably meaning bribery and kickbacks) accounts for some 8-12 percent of GDP. If, as I suspect, the Prime Minister is talking of graft and corruption as separate components, the size of Greece’s underground works out to some 18-21 percent of GDP. The result still falls short of the 25-30 percent of GDP estimated by most economists.
There is no question that Greece is caught between the proverbial rock and a hard place. To understand how the country got there, I shall try to trace the road map with the help of some basic economic data for the decade ending 2009. The first striking thing is that Greece ran a sizable current account deficit that grew from 6.6% of GDP in 2000 to 15.5% of GDP with most of the increase coming in the second half of the decade. A current account deficit basically arises from increases in import costs over export earnings. It is symptomatic of an excess of consumption over income. Greece financed this consumption boom not by drawing down domestic (public and private) savings or gross foreign exchange reserves of the central bank but through the contracting of external debt which swelled from a manageable 73% of GDP in 2000 to close to 160% of GDP by the end of the decade.
A recent study at Global Financial Integrity (GFI) found that illicit financial flows from developing countries (henceforth emerging markets), which grew around 18 percent per annum since 2002 swelled up to US$1 trillion in 2006. While the lack of prudent macroeconomic policies, political instability, and governance issues are major drivers of illicit flows, a subsequent study at GFI found that banking secrecy and lack of regulatory oversight facilitated the absorption of illicit flows in mainly Western financial institutions. Curtailing illicit flows must therefore involve both emerging market as well as developed countries to address the factors responsible for the generation and absorption of illicit funds.
Here we discuss the difficulty of addressing complex governance issues underlying the generation of illicit flows. We start by recognizing that the accurate measurement of complex governance issues through indicators is fraught with difficulties. This came to light in the course of GFI’s study. For instance, we noticed that illicit financial flows from many emerging markets were increasing even though their World Bank governance indicators were actually improving. As we discovered, this was not necessarily an anomaly—the Bank indicators were mainly focused on public sector governance while illicit financial flows are typically generated and driven by the private sector. The preponderance of the private sector in driving illicit flows can be illustrated by the fact that if corrupt government officials stash bribes abroad, they act in their private, and not official, capacity. Hence, public sector governance in some emerging markets could be improving even as their private sector governance deteriorates thereby generating illicit flows through, say, trade mispricing.
Most countries in the world are somewhere in-between a bipolar policy extreme characterized by either complete monetary dominance or complete fiscal dominance. Complete monetary dominance (equivalently zero fiscal dominance) is characterized by complete independence of the monetary authority. Under such a situation, any increase in debt (generated by the central bank selling government bonds in the open market) must be followed by increases in the current or future primary surplus (i.e., excess of the current government revenues from all taxes over current government expenditures) by the fiscal authority such that it is able to back the principal and interest payments on the newly issued debt. The other policy-mix extreme is complete fiscal dominance characterized by a monetary authority whose policies have been totally subordinated to the government. All outstanding debt is backed by the monetary authority in the form of current and future seigniorage revenues or that part of revenues accruing to the government through the creation of money (as in quantitative easing). A case of complete fiscal dominance would compel the monetary authority to fully accommodate the fiscal authority whenever a budget deficit is financed with debt. Obviously, the effectiveness of inflation targeting–arising out of the monetary authority’s pursuit of its primary policy objective—is reduced in the presence of fiscal dominance when monetary policy is subordinated to fiscal needs.
Illicit financial flows exit developing countries through two broad channels—as unrecorded capital flows from a country’s external accounts (captured by the World Bank Residual model) and trade mispricing (captured by the Direction of Trade statistics or DOTS model). GFI’s study Illicit Financial Flows from Developing Countries: 2002-2006 points out that some researchers have questioned the use of the trade mispricing model to capture illicit flows. They argue that data issues underlying the recording of partner country exports and imports introduce enough “noise” so that the trade mispricing model is unable to capture illicit flows. I was therefore not surprised to hear cynical remarks about the quality of bilateral trade statistics at a recent World Bank conference (Understanding the dynamics of the flows of illicit funds from developing countries, September 14-15). Here, I point out the reasons why most economists reject such arguments for not studying trade mispricing as a conduit for illicit financial flows from developing countries.
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