Archive for May, 2011

Understanding the Financial Meltdown

Monday, May 16th, 2011

The Big Short, Michael Lewis, 2010

Having read and commented on several works detailing the financial meltdown, including IOU, How Markets Fail, Too Big To Fail, and House of Cards , this reader still felt that something was missing from the account; how could all these “masters of the universe” have been so monumentally stupid as to not see the disaster they were inevitably creating?

Along comes Lewis, who chooses to focus on four individuals who saw the disaster coming before others and found ways to personally profit from the disaster by inventing new “shorting” strategies. Some reviewers have focused on David Einhorn who features in Sorkin’s work for his alleged role in leading the charge to short Bear Sterns and ultimately bring down the first Wall Street firm to fail. But this book puts the focus where it properly belongs on Dr. Michael Burry, a medical doctor who first became interested in investing while working long hours as an intern. He not only found time to research and invest while working long hours but started blogging about his research and investment strategies, thus coming to the attention of other investors. Interestingly, unlike Einhorn, whose primary investment strategy was looking for firms to short, Burry started out as a value investor in the mold of Warren Buffet. A value investor looks for companies whose stock price is so depressed, the company would be worth more if it were liquidated. Burry became so successful in his strategy he actually (thanks to his blog) got some New York investors to create a fund that he would manage. This fund effectively put an end to Burry’s career as a practicing doctor.

burry Dr. Michael Burry

Then, around 2004, for whatever reason but probably simply curiosity, Burry started researching the new sub-prime mortgage instruments deemed by most too complex to understand. Lewis believes that Burry was perhaps the only person in the entire world (perhaps other than the lawyers who created them) to read and understand the documents used to create these new instruments. Burry immediately intuited that these instruments were ticking time bombs and he picked a few to study in depth to understand the probable time line of their demise. But Burry had a problem. There was no obvious way to profit from his advanced knowledge of what was about to unfold in the market.

einhorn1 David Einhorn

Burry had been aware for a couple years of something called a credit default swap (CDS) which was actually an insurance policy one would take out on a corporate bond. Burry thought such an instrument was need for sub-prime mortgage “bonds” and convinced some wall street firms to offer them starting around 2005. The CDS then allowed Burry and others, like Einhorn, to place bets against specific sub-prime mortgage “bonds”. The really interesting thing I hadn’t previously realized was that one could buy a CDS on a mortgage bond without actually buying the bond itself. This is a bit like companies buying life insurance policies for their employees with themselves as beneficiaries. Burry is thus “patient zero” in the creation of an entire industry (admittedly small) dedicated to shorting the sub-prime mortgage market. Curiously, only a handful of people and institutions (four of which feature in this book) followed Burry into this market for shorting bonds. It was only at the end toward the collapse, that most of wall street who were holding these ticking time bombs started buying their own “insurance”. It was this last minute flurry that caused such huge losses at AIG (the biggest underwriter of CDS) and which resulted in much of TARP money making good on insurance payouts.

Most reviews of this book are misleading and lead one to wonder if reviewers actually bother to read the books they review. A somewhat lengthy excerpt was published in Vanity Fair around the time of publication that gives a an accurate sense of the book and of Burry’s central role in the market for shorting sub-prime mortgage bonds.

For this reader, one of the best aspects of Lewis’ book was not the figuring out how to bet against the collapse of this huge financial market, but the actual living through the demise from the point of view of those who had made huge bets that the market would collapse. First, sub prime mortgage bonds were not sold in a normal market with transparency and a readily available marketplace where they could be traded under fair and regulated conditions. So if a sub prime mortgage bond has clearly failed and insurance is owed, who exactly is responsible for declaring it worthless.

Our small group of shorters were shocked to discover how many of these bonds were still held by big Wall Street and banking firms as they failed. They naturally assumed that since it was obvious to them these bonds would blow up, the smart people running the big firms would know this as well and would have long since sold the ticking bombs to some other dumb suckers. They didn’t and when it finally dawned on the big firms they quickly started buying their own insurance policies at the last minute, transferring at least some of their liability to the underwriters like AIG. During this period while they were busy buying their own policies they had every incentive to hide the fact that the bonds had already failed. But here again, some firms were also underwriting and holding the bonds at the same time (monumental stupidity) and they reacted to the failure of the bonds by denying the bonds were worthless.

Without defined marketplaces and without well understood and enforced rules how were the shorters to get clear declarations that the bonds they were betting against had actually failed and the insurance was therefore owed?

Finally the scales tipped with TARP and some of the most toxic bonds were declared to have failed. The next big hurtle to getting paid was the likelihood that the insurers would themselves become insolvent and no insurance would be forthcoming. Again, step in the federal government to prop up the insurers and allow the shorters to be paid.

So these handful of people foresaw the collapse, figured out a way to bet that it would collapse, and profited by that collapse. Did they celebrate? By Lewis account most were shocked by the magnitude and breadth of the disaster they themselves predicted. After months of concern that they would ever see their bets pay off, most were equally shocked that Federal government intervention was almost the sole means by which their bets were made good. So there doesn’t seem to have been celebrations that these few had got it right and had been able to profit from being right. Many are now in new lines of work or have reverted to previous investment modes like Burry’s original value investing.

Shorting a world wide economic collapse didn’t, in the end, feel too good. Good reading, fascinating characters, and even a moral tale. who would have thought.

The vulnerable American University

Monday, May 16th, 2011

The Great American University, Jonathan R. Cole, 2009

This important work is a plea for the preservation of the unique American Research Universities that are currently the best in the world but that are unstable and vulnerable institutions. Cole, a lifelong Columbia University product, is uniquely qualified for this work because of his specialized training in the sociology of science and his career which culminated as provost (in charge of curriculum) at Columbia. He begins with a brief history of the American University, starting with the first, Harvard, and including a small number of private colleges, two of which, the University of Pennsylvania and the University of Virginia were founded by Benjamin Franklin and Thomas Jefferson respectively. He focuses on the period from 1870 to 1930. During the Civil War, the prescient Abraham Lincoln oversaw the creation of the land grant colleges where Federal land was made available to the states to establishes new colleges, and the establishment of the Federally funded agricultural extension services whereby advanced agricultural research and technical assistance to farmers could be conducted at the newly established land grant institutions. These acts led to the dramatic increase in the number of institutions of higher learning throughout the United States. An unanticipated result was the key role these new public “agricultural” colleges were to play in the increasingly urban and industrialized country that grew rapidly after the civil war. Cole also notes the critical influence of the “Robber Baron” class of monopolists whose extreme wealth led to several individuals endowing entire colleges (Stanford, Carnegie, Rockefeller) and establishing large foundations and grant organizations funding college research. But the rise in power of the monopolists also led to a backlash in the form of the Teddy Roosevelt led progressive movement which aimed to reign in the power and corruption of these wealthy monopolists. The impact on the colleges was a revolution in governance as a new level of professionalism, professional journals, and peer review came to replace the college presidents and board of governors or trustees as the focus of power and decision making in the schools.

vannever bush Vannever Bush

By 1930, the American universities were in the ascendancy but not yet recognized as the best in the world. Then came the great depression and the inauguration of two leaders in January 1933, FDR in the US and Hitler in Germany. By October 1933, Hitler had fired all Jewish public servants including University professors and started the greatest brain drain in educational and scientific research history. Some non Jews such as the theologian Paul Tillich, who openly opposed the Nazi regime were also fired and many other non Jews left German universities of their own accord. The exodus was not limited to Germany and many Austrian, Hungarian (Leo Szilard), and even Scandinavian (Danish Niels Bohr) professors who went on to make key contributions to the Manhattan project. By the end of WWII half of all German theoretical physicists had migrated to the US. The German Universities fell in stature from the best in the world in 1930 to mediocre and to this day have not recovered their former eminence. It is this sudden precipitate and seemingly permanent fall from dominance that leads Cole to fear for the fragility of the American research university system. By the end of WWII the American research university with its rich infusion of foreign talent was poised to become the best in the world. Enter Vannevar Bush, a key administrator for the Manhattan project and science visionary with the ear of FDR who wrote a treatise “Science-The Endless Frontier” outlining his vision of a unified federal grant agency with huge funds to support scientific research at American universities. The actual implementation was not a single agency (with Bush as its head as he envisioned) but a number of separate agencies, the NSF for general science, the NIH for biological and medical research, the DOD and its unique ARPA agency that supported social and scientific research without immediate military application and others. This set of agencies led to the huge infusion of grants and research monies that allowed the American Research Universities to enter their golden age of worldwide dominance and leadership in research.

clark kerr Clark Kerr

What was this uniquely American research university like? Clark Kerr, the man most responsible for the development of the national trend setting University of California system wrote in 1963 about the uniquely American universities:

A university anywhere can aim no higher than to be as British as possible for the sake of the undergraduates, as German as possible for the sake of the graduates and the research personnel, as American as possible for the sake of the public at large — and as confused as possible for the sake of the preservation of the whole uneasy balance.

Cole calls the period from 1963-1968 (LBJ) the golden age of the American research university. It was in this golden age that the social sciences received large grants for research and even the arts and humanities found large and sustained support. Vietnam was to put an end this golden age as campus protests and unrest led to the dismissal of at least two University leaders, the president at Columbia was fired for overreacting to student protests, and Clark Kerr at Berkeley, was removed by newly elected governor Ronald Regan for under reacting to protests at Berkeley. Cole asserts the it took two decades for Columbia to recover from this period and incident.

terman Frederick Terman

Cole spends some time looking at Stanford’s meteoric rise to become one of the leading research universities in the nation under Frederick Terman. Two of Terman’s students, Hewitt and Packard, were pioneers in establishing HP in the first industrial park wholly owned by Stanford, creating the legendary Silicon Valley with start ups like Fairchild, Intel, Sun, Apple, Google and hundreds of others. even Boston with Harvard, MIT and six other universities pales in comparison with the impact of Stanford (Berkeley and Cal tech deserve some credit) on the creation of Silicon valley.

Starting in the 1970s research grants moved almost completely away from the humanities and and social sciences and even to some extent away from pure science into computers and technology and most heavily into biological and medical science. Today about half of all Federal support for university research is spent on biomedical research. Until 1980 any patents resulting from Federally funded research belonged to the government. Then the Bayh – Dole act of 1980 assigned these patents to the universities where the research took place. This led to a profound change as the Universities were suddenly pushed into the role of technology licensers with huge potential payoffs. Stanford made $380 million from licensing the Google search patents to Google and similar windfalls have come from licensing drug and medical device patents.
Cole identifies three distinct types of research, pure science such as particle physics and space exploration where immediate application and benefits are unknown. Pure science is curiosity driven and it may be no accident that the world’s largest particle accelerator CERN was built in Europe. The second type of research is in areas that are likely to result in immediate application such as computer and nano-technology as well as solar and wind technologies. These areas of research are increasingly attractive to American universities because they can lead to immediate patents and revenue for the university. The third area is pure research that may lead to applications if breakthroughs are made in the research. This is typical of the biological, genetic, and medical areas where progress is uncertain. Much has been learned about cancer but cures are still rare and disorders like autism, Parkison’s disease, and Alzheimer are still beyond any possible cure. But these area remain hopeful that scientific breakthroughs will occur.

Cole spends the middle section of his book reminding us all of the contributions our Universities have made to improving our lives. This section is a useful reminder of the importance these institutions have had in our lives.

He ends with a history of three threats that severely endangered our universities, the red scares of 1917-1924 and 1949-1954 where faculty members were fired or at least silenced, and the post 9/11 Bush terror scare from 2001-2009, which Cole argues is the most serious of the three in its implications for the survival of the preeminent research University. First, the Patriot Act gives the FBI unprecedented and secret powers to gain access to university records on individual professors and students including library records. Cole argues that this leads to unnecessary self censorship and fear among members of the university community far beyond any actual prosecution. Second, the anthrax scare actually ruined several careers and new catch 22 rules about the handling of pathogens has led to a mass exodus of researchers from the study of infectious diseases. Third, the imposition of arbitrary religious convictions regarding embryonic stem cells has virtually stopped research progress in promising areas which delay had undoubtedly caused unnecessary death and suffering. When Nancy Reagan questions the ban you know something has done badly wrong. Finally the overt and successful censorship of professional journal articles and government research efforts, particularly in regard to global warming and sex education by the Bush administration bodes very ill for the continuing freedom and integrity of the peer reviewed scientific communication system. The Bush administration also attempted to completely suppress publications that they arbitrarily believed would be be useful and exploitable by potential terrorists.

The other big impact of the Bush terror war is on the admission of foreign students and hiring of foreign professors. There has been a huge drop in intellectual capital that cannot be met by American high schools. Increasing percentages of enrollment in the University of California system come from Asia but this rise has leveled under restrictive immigration policies. Even active professors working at American universities have lost their ability to return to their positions at great cost to the research they were conducting.

Perhaps the most interesting aspect of the book deal with trying to preserve a structure that is inherently a meritocracy (elitist), where only a few of the most talented are responsible for most of the gains and breakthroughs of the entire huge system. Cole talks about the internal threat posed by orthodoxy and dogma where a few individuals can gain control of a school of thought and close it to all possible challenges, killing criticism and any possibly of progress. He doesn’t give examples but this reader would offer the Chicago School of Economics where is seems to have happened. Milton Friedman and his associates so dominated discourse with their free market notions that empirical evidence simply was ignored. It was left to other schools to criticize the Chicago school (Stieglitz and Galbraith father and son) but the Chicago School held a stranglehold on government and government institutions like the IMF and World Bank throughout recent history. About the only positive thing about this example is the universe of research institutions is large enough that meaningful critical work can continue in these periods of orthodoxy.
Another risk comes from the increasing need of research universities to compete for the best talent and resources. The public universities like the California system are under enormous pressure as their states cut back on funding. They can only compensate by raising tuition and competing more effectively for research grants or by producing revenue generating licenseable technology. Somehow the states must be convinced to stop short changing their valuable research institutions and decrease this pressure before irreversible damage occurs.

Cole is also a strong believer the research university must remain strong in all areas including the social sciences, the arts and humanities. The research university must never divorce its research from its teaching function. The best and most productive members of the faculty in terms of research are usually the best at replicating themselves, training the next generation of researchers. It is also true that most innovation comes from young minds but that the rewards of grant moneys and laboratory facilities goes to older, established individuals. These gifted older individuals must train and offer laboratory opportunities to their students who will generate the next breakthroughs by bringing fresh perspectives to their work and research. The German system (as well as the Russian, Chinese, and Japanese) are authoritarian and hierarchical with absolute respect being owed to the senior professor. Visitors to American universities are always struck that professors and their graduate research assistants are on a first name, very informal basis. It is natural in this setting for the professor to offer gentle guidance based on experience but also to listen to new and even wild ideas from his assistants. This is the way to new discoveries.

Cole also talks a bit about the continuing struggle to broaden admissions to account for gender, racial, and income differences. Some universities like Harvard in the early 20th Century went on a campaign to rid its faculty and student body of Jews but other schools like Columbia and the University of Chicago simultaneously added disproportionate numbers of Jews to their faculties and student bodies. The great diversity of great American universities had no problem absorbing the large influx of Jewish European professor in the Nazi period. Cole finds it ironic the the Israeli lobby today is attacking those same institutions that offered refuge from the Nazis for hiring middle east professors and setting up programs to teach middle east language and culture. This lobby even attacks Jewish professors like Tony Judt for criticizing Israeli actions and policy. Columbia came under enormous pressure from the lobby when Palestinian Edward Said taught at Columbia.

How do you describe the unique American Research University? Here is Cole:

Great universities are designed to be unsettling. They challenge orthodoxies and dogmas as well as social values and public policies. They are the most effective instrument for creating skepticism and discontent with established institutions…Great teachers challenge the biases and presuppositions of their students and colleagues. They present unsettling ideas and dare others to rebut them and to defend their own beliefs in a coherent and principled manner. The American research university pushes and pulls at the walls of orthodoxy and rejects politically correct thinking.

Unsettling by nature, university culture is also highly conservative. It demands evidence before accepting novel challenges to existing theories and methods. The university ought to be viewed in terms of a fundamental interdependence between the liberality of its intellectual life and the conservatism of its methodological demands…We permit almost any idea to be put forward – but only because we demand arguments and evidence to back up the ideas we debate and because we set the bar of proof at such a high level. These two components — tolerance for unsettling ideas and insistence on rigorous skeptics about all ideas — create an essential tension at the the heart of the American research university.

So for all his fears about outside interventions from special interests, government, and industry, Cole ultimately fears most the threats from within the university itself if this unsettling tension is lost.

Finally Cole believes that competition among the leading universities is not only healthy but essential to maintain the absolute highest levels of achievement. This competition involves competing for endowments, grants, faculty, students, and even athletic achievement. He most worries that the wealthiest universities (Harvard dwarfs all other schools with its endowments) will increasingly have a competitive advantage and this will result in greater concentrations of talent and production. Only the Federal and state governments are in a position to redress this imbalance with increased infusions of support spread over the whole range of private and public universities. The new crop of super wealthy Americans like Gates and Buffet could also do a lot to redress the balance and create a more level playing field for the universities but currently Gates and Buffet are looking elsewhere where their money can have a global impact.

Island Secrets

Monday, May 16th, 2011

Treasure Islands, Nicholas Shaxson, 2011

While we are vaguely aware of secret bank accounts in Switzerland and the Caribbean, few actual studies and little journalism are done, maybe because facts are so hard to come by. Here is a compact work delving into the history and current state of offshore banking. It is short of figures because of the secrecy but Shaxson argues offshore banking is at the heart of recent financial crises and seemingly beyond the control of any government. The author, Shaxson, is British and perhaps only a Brit can adequately tell the story.

Lord Mayor Election Lord Mayor Show city flag

At the heart of this tale is the City of London which this reader thought was just a part of London where banks locate but is in fact a state within state, much like the Vatican, which traces its origins back to the Magna Carta – it predates Parliament. The City of London, covering a single square mile in the heart of London, has its own government with a Lord mayor at its head elected, not by people, but by corporations who have a vote in the City. The City of London was useful to the monarchs of England because they could borrow to pay for their domestic and international adventures. Then when England created its empire, the City of London was essential in financing that empire. The City reached its old zenith in the roaring twenties when even America had opened subsidiaries of their biggest banks in the City of London. This golden era ended with the crash of 1929, the great depression, the rise of fascism, and WWII. By the end of the war the City of London was a sleepy backwater whose bankers took three day weekends. Nonetheless, every November the City holds its Lord Mayor’s show an arcane ritual with guided coaches and elderly men in long satin robes.

keynes white John Maynard Keynes and Harry Dexter White at Bretton Woods

In 1944 John Maynard Keynes, the most brilliant Economist in history, helped negotiate the Bretton Woods agreement to control and limit international finance and create the IMF and the World Bank. This set of principals were to govern international banking until about 1970 and ushered in a period of continuous growth and prosperity for all leading economies.

The debts from WWII led to the breakup of the colonial empires, for Britain starting with the independence and partition of India in 1947 and culminating in the shocking nationalization of the Suez canal by independent Egypt in 1956.

bongo Omar Bongo’s Paris

But something else was going on in this period. Shaxon, working for Reuters, was interested in why oil producing countries in Africa were doing so poorly. The light finally went on during a trip to Gabon in 1997. Gabon became independent of France in 1960 and in 1967 France installed Omar Bongo, then only 32, from a small minority group who combined cunning, charisma, and loyalty to France. France stationed a small contingent of troops to assure Bongo could not be overthrown in a coup. Bongo was to rule Gabon continuously til his death in 2009. Gabon was to become the cornerstone of the Elf (Elf Aquitaine) system, a global system of corruption using Switzerland and Luxembourg as tax havens and secretly connecting former french colony African oil producers to politics in France. The Elf system allowed African oil money to secretly control the politics of France for the benefit of France’s biggest corporations.

georgetown Caymans hong kong Hong Kong

Shaxon was led to look again at the moribund City of London after the breakup of the British empire. Starting in the 1950’s, the City of London was busily constructing its own labyrinth of offshore banking havens in an elaborate three tier system made from the remnants of the empire. The first tier were the crown dependencies, the islands of Jersey, Guernsey, and Man. The second tier consisted of seven of Britain’s Overseas Territories with the Queen as head of state; Antigua, Bermuda, the British Virgin Islands, the Cayman Islands, Gibraltar, Montserrat, and the Turks and Caicos Islands. The third tier consisted of Hong Kong and a scattering of other small remnants of empire in the Pacific and elsewhere. The City of London was to keep two sets of books, one for onshore banking and another for offshore banking. Secrecy and an absence of regulation or oversight was the mainstay of the offshore system. Big American banks like Citibank and Chase quickly realized that they could get around the restrictions of the Glass Steagall Act of 1933 which prevented banks from investment or casino banking, by opening subsidiaries in the offshore side of the City of London. By 1960 in France, Britain, and America the highly regulated banking systems and the Bretton Woods conventions were fast eroding. While Thatcher and Reagan continued the national erosion of regulation in the 1980’s the horses had long before left the barn for the offshore system. The Reagan – Thatcher liberalization efforts were attempts to allow domestic financial institutions to catch up with the runaway Euromarket. The Lord Mayor of the City regularly lobbies for liberalization and deregulation, making twenty trips a year to places like China and India. Insider trading has been a regular feature of activities within the offshore system where secrecy and the lack of any regulations lead to an anything goes environment. Out of the ashes of European empire and the fall of Suez rose the Euromarket, an unregulated new empire with its heart in the City of London. A 1957 commission studying the City of London concluded “Logic has its limits and the position of the City lies outside them.”

In 2008 the City accounted for half of international equity trades, 45% of over the counter derivatives, 70% of Eurobond turnover, 35% of international currency trades, and 55% of international IPOs. Yet the City remains all but invisible to historians, political analysts, and the media. The AIG subsidiary that cost US taxpayers $180 Billion operated from the City.

We think of the offshore world as the domain of organized crime, and so Shaxson treats us to a brief history of the pioneering work of mob boss Mayer Lansky who perfected the art of money laundering through Bermuda and Switzerland, converting illicit gains into south Florida real estate. Lansky built the casino and entertainment system in Cuba then “retired” to Miami Beach in 1959 when Castro overthrew the Batista government. Lansky died in 1983 in Miami Beach where he was locally portrayed as this nice grandfatherly benign old man.

Shaxson also treats us to a history of the origins of the modern multinational corporation via the Vestey brothers who built a fully integrated meat monopoly in the early 20th Century around Latin American and Australian producers. The brothers controlled every aspect of the business from production to shipping and storage to marketing. Their principals of operation were – create a monopoly, squeeze the ends (producers and markets) to push the profits to the middle, don’t tell anyone what you are doing, avoid taxes at all costs. By the first world war the brothers were the wealthiest people in Britain yet they paid no taxes at all. They ignored all suggestions that they were not patriotic and were given honorary titles. Their secret weapon of choice to disguise their activities and avoid taxes was the trust. The Vestey brother’s principals are practiced by virtually all modern multinational corporations. Oil multinationals are a classic example of the Vestey style in the modern multinational corporation. The resource owners are squeezed with low royalties as are the consumers with high prices. The profits are squeezed into the middle where they may be opaquely hidden from tax collectors and other stakeholders. It is impossible for shareholders, auditors, let alone management, to figure out how the oil companies actually operate. The Elf system is alive and well in the oil industry.

While trusts are still used offshore, modern secrecy assures that governments cannot trace activities or tie them to individuals or corporations. With the Swiss system, individuals or corporations must fully disclose their identities and the Swiss promise not to tell anyone. With modern offshore systems, accounts are created by proxy and queries will only lead to a lawyer someplace that can protect the identity of the owner by invoking attorney-client privilege. If this is not enough, accounts can be set up to trigger instant electronic closure and movement and erasure of all banking records when an inquiry is detected. Some offshore jurisdictions not only criminalize disclosure of account information, but criminalize the making of inquiries. It is little wonder that so little is known about offshore banking.

So what do we know about this offshore system? The Euromarket grew from a net $500 Billion in 1980 to $1.7 Trillion in 1988. By 1997 90% of international loans were made through this market. We know that Enron had 881 offshore subsidiaries when it went bust; that in 2008 Citigroup had 427 tax haven subsidiaries, Morgan Stanley had 290, and News Corporation (Fox News) had 152. We know that the Cayman Islands had deposits in 2007 totally $1.7 Trillion, that Hong Kong in 2007 had deposits totaling $149 but growing fast. Hong Kong is the center of most corruption activity in China. It is estimated that the United States loses $100 Billion a year in taxes to tax havens. About a third of deposits come from corrupt individuals and organized crime including terrorist networks. Drug sales alone account for $500 Billion annually, more than twice Saudi Arabian oil revenues. That leaves two thirds of deposits to multinational corporations. This makes it virtually impossible to attack or control off shore banking due to the political power of these corporations. And all multinational corporations seem to engage in offshore activities including Cisco and Google, putting a lie to their “do no harm” slogan. Bono, raiser of millions through charitable concerts, uses off shore tax havens. More than 60% of total international trades take place between subsidiaries of the same multinational corporation. The purpose of these trades is opacity from shareholders and auditors and tax avoidance. In a generally ignored detail, LTCM which collapsed in 1998 operated offshore from the Cayman Islands.

For the US, twenty five years of tax cuts “has produced not trickle down — but Niagara up. Much of this new concentration of wealth finds it way offshore.

While wealthy countries lose taxes and regulatory control to the offshore system, the biggest impact is felt in the developing world. Shaxson says that the principal foundation of modern democracy is taxation with representation. It is the interaction between elected officials and the citizens to determine the level of taxes and the use to be made of those taxes by government that underpins the entire system of proper governance. This system is undermined or never allowed to develop in countries that are dependent on minerals for financial resources or become dependent on international aid and finance. And when wealthy individuals lack confidence in the local institutions of government there is an irresistible urge to move their wealth to safe (i.e. hidden) offshore locations, denying the governments both tax revenues and pressure to develop and build stable institutions. A US Federal Reserve official noted “The problem is not that these (latin American) countries don’t have any assets. The problem is, they’re all in Miami.” South Florida banks do not share their deposit information with Latin American countries. As a measure of the damage of capital flight, it is estimated that for every $1 given in foreign assistance $10 flows out to offshore locations at the same time. Much of the $1 itself finds its way soon enough in flight. A study estimated capital flight from 40 African countries from 1970 to 2004 at $607 Billion. Total external debt for these countries in 2004 was $227 Billion. Taken as a whole Africa is a net creditor to the rest of the world. But — “The subcontinent’s private external assets belong to a narrow relatively wealthy stratum of its population, while the public external debts are borne by the people through their governments.” Another study showed that most of Argentina’s external public debt was owed to wealthy Argentines operating offshore.

First bankers lent these countries far more than they could productively absorb; then they taught the local elites the basics of how to plunder their countries’ wealth, then conceal it, launder it, and sneak it offshore. Then the IMF helped bankers pressure these countries to service their debts under threat of financial strangulation.”

He also talks about the race to the bottom in offshore, this time including individual US states which practice a type of offshore activity by promoting lenient regulation and secrecy. All the corporations or entities need do is find some legal jurisdiction somewhere in the world to do their bidding and the rest of the world immediately jumps on board. He uses the example of the dismantling of US usury laws which were repealed first in South Dakota and then in Delaware. Most credit card issuers moved immediately to these states around 1980 and credit card issuance and debt took off. His next example involves the big four accounting firms who audit most multinational corporations books and were organized as limited partnerships. As off book subsidiaries and other accounting tricks came into common use, the big four started to worry about their personal liabilities. The collapse of Enron also destroyed their accounting firm Arthur Anderson LLP, showing the the big four had reason for concern. The big four chose Jersey to create a legal framework for organizing as limited liability partnerships. After a fight in Jersey, the law was changed and in 2001, the City of London approved the same legislation. The big four immediately converted from partnerships to LLPs.

How damaging is offshore? Between 1940 and 1971 there were no banking crisis and only 16 currency crises. Since 1971 there have been 17 banking crises and 52 currency crises. Looking back at 800 years of banking, liberalization of banking always leads to banking crises.

Who populates this offshore world. A bizarre mixture of old continental European aristocrats, Ann Rand libertarians, members of the worlds intelligence communities, global crime networks, assorted lords and ladies and bankers everywhere. Their common enemies are governments, laws, and taxes. Their code of silence rivals the Sicilians and even those who leave the world in disgust are reluctant to talk about it and refuse to reveal identities.

levin Carl Levin graham Graham at UBS

In conclusion, Shaxson believes that the richest nations can bring the off shore banking system under control even acting unilaterally, one by one. He gives the example of Carl Levin, long seeking transparency in offshore banking, who, after the departure from the Senate of Phil Graham of Texas for Swiss investment bank UBS, was able to pass a simple measure banning transfers between US banks and foreign shell banks, those operating anonymously. Overnight, thousands of shell banks were reduced to a few dozen. Levin appears repeatedly in this account for his statements and attempts to limit offshore banking.

Shaxson urges all nations to return to the original bargain made between their governments and corporations, a guarantee of limited liability for individual stakeholders and the granting to the corporation of many of the rights of the individual in return for operating transparently for the benefit of all stakeholders whether management, stockholders, customers, or suppliers, and the payment of taxes in full and without delay. Any corporation refusing to abide by the bargain should have their charters revoked and should be banned from doing business within the country. The problem with carrying this out is the degree to which the rich nations have become client states of the multinational corporation. Shaxson believes this would pose a particular difficulty in Britain where the ancient traditions of the City of London have almost always thwarted any attempts at reform. As to the threat that the multinationals will move their business elsewhere, Shaxson believes their offshore activities are so toxic to the host country that their loss may not be such a bad thing. And if the wealthy nations can deny multinational corporations and offshore banks access to their citizens and markets, the huge system would soon wither.