Treasure Islands: Dirty Money, Tax Havens and the Men Who Stole Your Cash

by Nicholas Shaxson

  The quarter century that then followed, from around 1949, in which Keynes’s ideas were widely put into place, has become known as the golden age of capitalism: an era of widespread, fast-rising, and relatively untroubled prosperity around the world. As Britain’s prime minister Harold Macmillan put it in 1957, “Most of our people have never had it so good.” From 1950 to 1973, annual growth rates amid widespread capital controls (and extremely high tax rates) averaged 4.0 percent in the United States and 4.6 percent in Europe. Not only that, but as the Cambridge economist Ha-Joon Chang notes, the per capita income of developing countries grew by a full 3.0 percent21 per year in the 1960s and 1970s, significantly faster than the record since then. And from the 1970s, as capital controls were progressively relaxed around the world, and as tax rates fell and the offshore system really began to flower, growth rates fell sharply. The countries that have grown most rapidly, the top-ranking economists Arvind Subramanian and Dani Rodrik explained in 2008, “have been those that rely least on capital inflows . . . financial globalisation has not generated increased investment or higher growth in emerging markets.”22

  Average growth is one thing, but to get an idea of how well most people are doing, you need to look at inequality, too. In the offshore era from the 1970s onward, inequality has exploded in country after country. According to the U.S. federal Bureau of Labor Statistics, the average American nonsupervisory worker was actually receiving a lower hourly wage in 2006, adjusted for inflation, than in 1970. Meanwhile, the pay of American CEOs rose from less than thirty to almost three hundred times the average worker’s wage. Nor is this just a story about growth and inequality. Another famous study found that between 1940 and 1971, a period mostly covering the time of the golden age, developing countries suffered no banking crises and only sixteen currency crises, whereas in the quarter century after 1973 there were 17 banking crises and 57 currency crises. A major new study in 2009 by the economists Carmen Reinhardt and Kenneth Rogoff, looking back over eight hundred years of economic history, concluded that, as reviewer Martin Wolf put it, “Financial liberalisation and financial crises go together like a horse and carriage.”23

  We cannot infer too much from these very different episodes. Other reasons exist for the high growth rates during the golden age, not least postwar rebuilding and productivity improvements during the war. The 1970s oil shocks go some way toward explaining the subsequent slide into crisis and stagnation.

  Still, less drastic but nevertheless powerful conclusions do emerge. The golden age shows that it is quite possible for countries, and the world economy, to grow quickly and steadily while under the influence of widespread and even bureaucratic curbs on the flow of capital, and high taxes. China carefully and systematically restricts inward and outward investments and other flows of capital, and at the time of writing it is growing fast. Clearly these kinds of controls, unfashionable for so many years, ought to be a policy option. Mainstream thinking on this is, at last, shifting a little: In February 2010 the IMF issued a paper24 outlining what would have been considered heresy just a few years earlier, arguing that capital controls are sometimes “justified as part of the policy toolkit” for an economy seeking to deal with surging inflows. Very often countries can, as Keynes believed, get along perfectly well with their own domestic credit systems and localized capital markets, without exposing themselves to the killer seas of global offshore finance.

  What has happened since the golden age ended is not simply a return to the free movement of capital but financial liberalization on steroids. The offshore system that tore financial controls apart from the 1970s has been both an accelerator for flighty financial capital but also a distorting field, bending capital flows so that they end up not necessarily where they can find the most productive investment but where they can find the greatest secrecy, the most lax regulations, and freedom from the rules of civilized society. It would seem sensible to take our foot off the accelerator.

  Quite soon after Keynes’s death a new ideological insurgency took hold, based on an idea of the near infallibility of free financial markets, which overthrew Keynes’s ideas. The Chicago economist Robert Lucas would write in 1980 that “at research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another.”

  The latest financial crisis, which, I will show later, had its roots substantially in offshore finance, has helped resuscitate Keynes’s ideas, at least in some circles. “If your doctrine says that free markets, left to their own devices, produce the best of all possible worlds, and that government intervention in the economy always makes things worse, Keynes is your enemy,” wrote the economist Paul Krugman. “And he is an especially dangerous enemy because his ideas have been vindicated so thoroughly by experience.”

  Parallel with the ideological changes, however, something else began to emerge, even before the golden age ended. It first appeared in the City of London, before being embraced by Wall Street and spreading across the globe. Ideology mixed liberally with cash would create the conditions for the construction of a new world of offshore.

  4

  THE GREAT ESCAPE

  How Wall Street Regained Its

  Powers by Going Offshore to London

  AS THE BRETTON WOODS SYSTEM THAT KEYNES helped design got properly under way after the Second World War, Wall Street was tied down at home with domestic regulations, many dating from the Great Depression. Financial flows across borders were constrained, taxes were high, and the U.S. economy was growing very nicely indeed. Across the country working people were buying refrigerators, televisions, and new cars for the first time.

  Wall Street bankers wanted an escape route. They found it in a new offshore market in the City of London, the financial district at the geographical center of the greater London metropolis.

  Nobody quite agrees when this new strain of offshore activity first emerged, but it was probably first spotted by a financial regulatory authority in June 1955 when staffers at the Bank of England, the UK’s central bank, noticed some odd trades going on at Midland Bank, now part of the globetrotting HSBC.1 Exchange rates in those days were mostly fixed against the dollar, and banks in London were not supposed to trade in foreign currencies unless it was for financing specific trades for their clients, and they were not allowed to lend against deposits in foreign currencies. Midland Bank was apparently contravening UK exchange controls by taking U.S. dollar deposits that were not related to its commercial transactions, and it was also offering interest rates on these dollar deposits that were substantially higher than those permitted by U.S. regulations. A Bank of England official called in Midland’s chief foreign manager for a chat, to ask why the bank was contravening official controls. Afterward he noted down that the Midland official “appreciates that a warning light has been shown.”2 Luckily for Midland, though, Britain was struggling to shore up its shaky foreign exchange reserves, and the Bank was reluctant to snuff out a new area of international business. “We would be wise, I believe, not to press the Midland any further,” the Bank concluded.3

  Regulation in the City of London in those days typically consisted of your being invited to the Bank of England for tea, where an eyebrow would be raised in your direction if you were out of line. The tradition in London then, as today, was to rely heavily on self-regulation by financial firms, in stark contrast to the United States and its regulatory authorities’ far more activist, rules-based approach. The City of London proceeded along the lines of a grand British Old Boys network, bound by elaborate rule and ritual. Discount brokers would wear top hats, and every evening in the rush hour a platoon of guardsmen would troop through the City in scarlet tunics and bearskins. “A banker could show his disapproval of sharp practice by crossing the road,” wrote Anthony Sampson in the 2005 edition of his book Anatomy of Britain. “Behind all the conventions lay the assumption of a club based on common values and integrity. It was a club which could easily work against the interests of t
he public or outside shareholders, through insider trading and secret deals; and it was based on cartels which could exclude competitors and newcomers. But it was also quite effective.”4 A firm handshake and membership in the right kind of club was often enough to secure a man’s credit.

  As in the United States, however, finance was still relatively closely tethered, at least when compared to today, and the City of London was deep in a slumber. “By Thursday afternoon at four,” one U.S. banker remembered, “one of the senior partners would come across to the juniors and say, ‘Why are we all still here? It’s almost the weekend.’”5 Oliver Franks, a chairman of Lloyds Bank, compared it to driving a powerful car at 20 miles per hour. “The banks were anaesthetised,” Franks said. “It was a kind of dream life.”6 American banks overseas were similarly quiescent.7 For much of the time since the turn of the twentieth century they had been, as one account describes them, “courtesy stations where rich aunts could get their checks cashed or have a trust officer keep an eye on investments. Their nephews and nieces on short European tours used the bank, and so did a few vacationing businessmen.”8 Ambitious U.S. business school graduates would prefer cutting-edge manufacturing jobs than stodgy, old-fashioned banking.

  It is hard to imagine those days now: an era when international bankers took a backseat and fumed impotently at politicians’ mighty powers. Those few years after the Second World War were, in fact, the only time in several hundred years when politicians had any real control over the banking sector in Britain. And with Midland’s funny trades from 1955, and the Bank of England’s decision not to interfere to stop it, that control began to unravel.

  Just then, Britain’s formal empire was starting to crumble too. India had secured independence in 1947, communist guerrillas were attacking British colonialists in Malaya, Egypt had broken free, civil war was breaking out in Sudan, and Ghana was preparing for independence. In July 1956, just over a year after the Bank started noticing Midland’s funny trades, Egyptian president Gamal Abdel Nasser nationalized the Suez Canal. Britain and France, trying to adjust to their less magisterial postwar roles in world affairs but still driven by imperial-era motivations and arrogance, joined Israel in a three-sided invasion. It was a colossal mistake: The U.S. forced them to retreat, humiliated. “It marked, with brutal clarity, the end of Britain as a world power,” said David Kynaston, historian of the City of London. It was the trigger for the collapse of the British Empire: Within a decade, an empire that had ruled over 700 million foreigners at the end of the Second World War shrank to a population of just five million.

  As the empire crumbled, the pound—then fixed against the U.S. dollar at $2.80 per pound—began to totter and with it the whole edifice of solid, dependable imperial finance.9 Coming less than a decade after Henry Morgenthau, the U.S. treasury secretary, had declared his intention to “move the financial center of the world from London and Wall Street to the U.S. Treasury,” it was almost too much for the whiskery old gentlemen capitalists in London to bear.

  In 1957 the British authorities, in a last-ditch attempt to rescue sterling’s old imperial role, raised interest rates and applied new curbs on overseas lending to protect the pound. But the London banks, having noticed that the Bank of England had decided not to stop Midland’s trades, sidestepped the new curbs by shifting their international lending away from sterling and into dollars, in this new market. And here is the crucial part: The Bank of England not only did not stop Midland’s trades, but it actively decided not to regulate the market either. It simply deemed the transactions not to have taken place in the UK for regulatory purposes. Since this trading happened inside British sovereign space, no other regulatory authority elsewhere was allowed to reach in and regulate it, either.

  Banks in London began keeping two sets of books—one for their onshore operations, where at least one party to the transaction was British, which was regulated, and one for their offshore operations, where neither party was British.

  A new offshore market had been born, which would become known as the Eurodollar market or the Euromarket.10 It was no more than a bookkeeping device, but it would change the world.

  The new unregulated Euromarket that emerged amid the dust and fire of Suez would grow explosively and become nothing less than the heart of a new British financial empire centered on the City of London. It would raise the City to even greater financial glories, provide a new playground for U.S. banks, and prove the key to resurrecting an old alliance between the City of London and Wall Street, helping each break the grip of their governments at home and restore them to their full powers.11

  “As the good ship Sterling sank, the City was able to scramble aboard a much more seaworthy young vessel, the Eurodollar,” wrote P. J. Cain and A. G. Hopkins, the leading historians of British imperialism. “As the imperial basis of its strength disappeared, the City survived by transforming itself into an ‘offshore island’ servicing the business created by the industrial and commercial growth of much more dynamic partners.”12

  Modern histories of the City of London’s growth as a financial center point to the “Big Bang” of 1986—the sudden deregulation of London’s markets under Prime Minister Margaret Thatcher—as the moment when London really took off in its modern form. But Tim Congdon, one of the City of London’s most experienced spokesmen, spotted the real story. “The Big Bang,” he wrote in 1986, “is a sideshow to, indeed almost a by-product of, a much Bigger Bang which has transformed international finance over the last 25 years. The Bigger Bang is—on all the relevant criteria—a multiple of the size of the Big Bang.”13 “An extraordinary situation has arisen where the Euromarket, which has no physical embodiment in an exchange building or even a widely recognised set of rules and regulations, is the largest source of capital in the world.”14

  The scholar Gary Burn put it in a different light. The market’s emergence, he said, was “the first shot in the neo-liberal counter-revolution against the social market and the Keynesian welfare state.”

  The modern offshore system did not start its explosive growth on scandal-tainted, palm-fringed islands in the Caribbean or in the Alpine foothills of Zurich or Geneva. It began its life in the City of London. American banks would soon dominate this market utterly. And, as is usual with so much that has happened offshore, very few people outside the financial sector even noticed.

  Before proceeding with this tale, it is essential to understand something peculiar about the City of London.

  Few British people, let alone anyone else, know that the City of London is the most important financial center in the global offshore system. Before getting properly into the strangeness of this ancient city, some of its more obvious offshore qualities are worth noting.

  London’s first claim to be a tax haven is the subject of this chapter: its role as the creator and developer of the Euromarkets, Wall Street’s giant escape route from the checks and balances of U.S. financial regulation. Here the subsidiaries and affiliates of U.S. commercial banks have long been allowed to engage in, among many other things, investment banking—“casino banking,” as some have called it—something the Glass-Steagall Act of 1933 explicitly prohibited. Over the years, as this business became more integral to their global banking models, Wall Street could increasingly pressure the U.S. government to do away with the original restrictions to allow them to do at home what they already did offshore, and this was arguably the main factor that led to the repeal of Glass-Steagall in 1999. It was the classic offshore pattern: banks find an offshore escape route, then say in Washington, “We can already do this offshore—so why not here?”—and domestic regulations get relaxed.

  London provides endless loopholes for U.S. financial corporations, and many U.S. banking catastrophes can be traced substantially to those companies’ London offices. The unit that blew up the insurance company American International Group (AIG), putting the U.S. taxpayer on the hook for $182.5 billion, was its four hundred–strong AIG Financial Products unit, based in London. Th
e court-appointed examiner looking into the collapse of Lehman Brothers in September 2008 found it had used a trick called Repo 105 to shift $50 billion in assets off its balance sheet, and that while no U.S. law firm would sign off on the transactions, a major law firm in London was delighted to oblige, without breaking the rules.15 When the United States introduced the Sarbanes-Oxley regulations to protect Americans against the likes of Enron or Worldcom, the City of London did not follow, and more U.S. financial business flowed to London.

  Another important role for London has concerned a seemingly arcane practice known as “rehypothecation,”16 a way of shifting assets off banks’ balance sheets. The U.S. has firm rules to curb the abuses, but London does not—so ahead of the latest crisis, Wall Street investment banks simply went off to London where they could do it without limit. A little-noticed IMF paper in July 2010 estimated that by 2007 the seven largest players in the market—Lehman Brothers, Bear Stearns, Morgan Stanley, Goldman Sachs, Merrill/BoA, Citigroup, and JPMorgan—had shifted $4.5 trillion off their balance sheets in this way. So this London-based practice injected trillions more debt into the financial system than would otherwise have been the case.17 The City of London and Wall Street banks got rich off this—and ordinary Americans will pay for it for years to come.

  World oil markets are also affected by the London loophole. In June 2008, as world oil prices soared amid uproar about market manipulation, former regulator Michael Greenberger noted in testimony to a U.S. Senate Committee18 that the U.S. Commodity Futures Trading Committee (CFTC), the regulator for energy derivatives, had been pursuing a “continuous charade that a U.S. owned exchange (ICE) located in Atlanta and trading critically important U.S. delivered energy products should be regulated by the United Kingdom, whose regulation of these markets is self evidently lacking.” Almost every Russian firm listing overseas chooses London, not New York, partly because of Britain’s permissive governance standards. The list of London loopholes goes on.