How tax havens and wealth inequality encourage speculation
The FT published an op-ed today on the role tax havens play in exacerbating financial speculation:
Banks employ large teams of highly paid people to devise transactions mainly for the purpose of avoiding tax. These activities seem to be far more profitable than the humdrum business of managing payments and channelling savings towards investment. Why?
The answer shows the close link between tax avoidance and the speculation that has fuelled financial instability for 30 years. There were clearly other causes of the current crisis but the faults of the international tax system were a big contributory factor.
Take hedge funds, for example. The tax authorities in the US and the UK have accepted a lax interpretation of residence and source rules, accepting that these funds are resident and their profits sourced offshore (mostly in the Cayman Islands) – even though they are effectively managed from London and New York. Not only are the funds’ gains treated as realised in Cayman, and hence not taxable, but their distributions are not subject to withholding tax – a great benefit for their investors. The funds’ location in a secrecy jurisdiction facilitates tax avoidance and is an open invitation to evasion.
For multinationals and rich investors the point is the same: returns on financial transactions are ultimately taxed at a low or zero rate, making them far more profitable than genuine business endeavours. This distortion of the tax system has greatly fuelled the excess of liquidity channelled into largely speculative financial transactions. The offshore secrecy system has been a main element of the opacity that has undermined corporate and financial regulation.
For similar reasons, I believe one may formulate an argument along these lines explaining why income inequality is undesirable, even if one has no socialist proclivities. I once argued with a friend who propounded the argument that there is nothing inherently wrong with income inequality and hugely lopsided wealth distribution. A possible drawback is that a great disparity in wealth distribution means that the wealthy hold much more money than the middle-class and this wealth often make their way to hedge funds and other risk-taking investment firms (perhaps including investment banks which are supposedly more risk-adverse than hedge funds).
In return, what do these fund-laden hedge funds do? They invest all the excess riches in speculative endeavours. The world and in particular the middle-class groups were on the receiving end of this last year, when oil prices shot up to US$140 a barrel, in large part driven by funds engaging in speculation:
“Approximately 60 to 70 percent of the oil contracts in the futures markets are now held by speculative entities. Not by companies that need oil, not by the airlines, not by the oil companies. But by investors that are looking to make money from their speculative positions,” Gilligan explained.
Gilligan said these investors don’t actually take delivery of the oil. “All they do is buy the paper, and hope that they can sell it for more than they paid for it. Before they have to take delivery.”
“They’re trying to make money on the market for oil?” Kroft asked.
“Absolutely,” Gilligan replied. “On the volatility that exists in the market. They make it going up and down.”
In fact this got so bad that a legislative ban on oil investments on hedge funds was considered, but ultimately never passed by the US Senate. Here’s a closer examination of the role investment banks and hedge funds on Wall St. played:
Masters believes the investor demand for commodities, and oil futures in particular, was created on Wall Street by hedge funds and the big Wall Street investment banks like Morgan Stanley, Goldman Sachs, Barclays, and J.P. Morgan, who made billions investing hundreds of billions of dollars of their clients’ money.
“The investment banks facilitated it,” Masters said. “You know, they found folks to write papers espousing the benefits of investing in commodities. And then they promoted commodities as a, quote/unquote, ‘asset class.’ Like, you could invest in commodities just like you could in stocks or bonds or anything else, like they were suitable for long-term investment.”
Morgan Stanley isn’t an oil company in the traditional sense of the word – it doesn’t own or control oil wells or refineries, or gas stations. But according to documents filed with the Securities and Exchange Commission, Morgan Stanley is a significant player in the wholesale market through various entities controlled by the corporation.
It not only buys and sells the physical product through subsidiaries and companies that it controls, Morgan Stanley has the capacity to store and hold 20 million barrels. For example, some storage tanks in New Haven, Conn. hold Morgan Stanley heating oil bound for homes in New England, where it controls nearly 15 percent of the market.
The Wall Street bank Goldman Sachs also has huge stakes in companies that own a refinery in Coffeyville, Kan., and control 43,000 miles of pipeline and more than 150 storage terminals.
And analysts at both investment banks contributed to the oil frenzy that drove prices to record highs: Goldman’s top oil analyst predicted last March that the price of a barrel was going to $200; Morgan Stanley predicted $150 a barrel.
Unsurprisingly, all this happened due to de-regulatory laws passed by Congress:
It’s impossible to tell exactly who was buying and selling all those oil contracts because most of the trading is now conducted in secret, with no public scrutiny or government oversight. Over time, the big Wall Street banks were allowed to buy and sell as many oil contracts as they wanted for their clients, circumventing regulations intended to limit speculation. And in 2000, Congress effectively deregulated the futures market, granting exemptions for complicated derivative investments called oil swaps, as well as electronic trading on private exchanges.
But some of them may now be looking for work. The oil bubble began to deflate early last fall when Congress threatened new regulations and federal agencies announced they were beginning major investigations. It finally popped with the bankruptcy of Lehman Brothers and the near collapse of AIG, who were both heavily invested in the oil markets. With hedge funds and investment houses facing margin calls, the speculators headed for the exits.
“From July 15th until the end of November, roughly $70 billion came out of commodities futures from these index funds,” Masters explained. “In fact, gasoline demand went down by roughly five percent over that same period of time. Yet the price of crude oil dropped more than $100 a barrel. It dropped 75 percent.”
Who bears the brunt of this oil price hike? Why the middle and lower income groups of course. These were the people, in the US at least, whose heating bills went through the roof along with the cost of gas a gallon. Did the people stand to gain in any way from what hedge funds were doing? Not unless they’ve personally invested in those themselves which is off-limits to all but the richest. The end result? A familiar saying. The rich get richer and the poor poorer. Of course one might argue that hedge funds and other financial speculative entities would still exist in a less unequal society, but the point is the huge disparity of wealth distribution mean that hedge funds have more leverage with which they could use to corner the market and drive up prices.