Democracy Lab

Dirty Laundry

If the West really wants to prevent developing countries from laundering money, it can start by cleaning up its own act.

In case you haven't noticed, there is little enthusiasm left for sending money to the governments of developing countries as a means of digging their economies out of extreme poverty. In part, that's because some emerging-market countries (think China and India) are growing nicely without aid, while some big recipients (think Tanzania and Pakistan) have largely squandered it. Worse, aid programs are dogged by scandal, as corrupt elites appropriate the goodies -- and in some ironic cases, return the loot to their own bank accounts in donor countries.

Indeed, if these wayward funds could be redirected into productive uses in recipient countries, it could replace a good chunk of the aid that now comes from governments. Reducing the portion of the dollars that arrive as foreign aid and flow out as predators' assets would also help rebuild the discredited case for official development assistance. Hence the new interest in measuring (and containing) illicit cash crossing borders.

Illicit fund flows (IFFs for short) come from many sources. But the most prominent have been infamous kleptocrats -- among them Gen. Sani Abacha of Nigeria, Vladimiro Montesinos, the former head of Peru's secret police, and, most recently, Hosni Mubarak of Egypt. All three dipped freely into their countries' treasuries, parking much of their booty overseas in the form of luxury houses in the south of France or London, or as bank deposits in Jersey or Switzerland. The problem is so large that the World Bank and the United Nations started a program called the Stolen Asset Recovery Initiative (StAR) in 2007 to help victimized governments recover assets.

Kleptocracy is by no means the only source of IFFs, though. Tax evasion is almost ubiquitous in the developing world (at least among the wealthy), and it is likely that much of this money also ends up in deposits overseas. Trade mispricing - e.g. exporting goods for less than they're worth and collecting a kickback at the other end -- is a major channel for moving corporate profits overseas into less heavily taxed jurisdiction.

Some observers believe that criminal markets, such as drugs and human trafficking, are also important sources of illicit flows. But it is more likely that, on balance, they generate illicit inflows: Colombian drug dealers have wanted to repatriate enough of their earnings abroad that, in periods of currency restrictions, the official rate for Colombian pesos has been below that in the black market.

Note, moreover, that "illicit" is not the same as "illegal." When Ugandan officials negotiate sweetheart oil leases with side payments to their personal accounts, one consequence is higher revenues flowing out in the form of oil company profits. Those profits may be legal; but as the result of the corrupt negotiations, a share might reasonably be called illicit. The Extractive Industries Transparency Initiative, created in 2002 as a cooperative effort of 35 resource-rich countries, aims to prevent such corrupt contracting. But even if successful, existing contracts will be generating illicit flows for the foreseeable future -- no reason, after all, to waste a good bribe on a short-term deal.

How large are IFFs in total? The phenomenon has been much-discussed at G20 meetings and other high-level confabs since the 2005 publication of Capitalism's Achilles Heel: Dirty Money and How to Renew the Free Market System by Raymond Baker (now the director of the non-profit, Global Financial Integrity). Startlingly, no research on the subject has appeared in the mainstream economics literature. The only estimates come from the advocacy community, and are troublingly, even implausibly, large. Global Financial Integrity says the figure is about $1 trillion per annum -- dwarfing total development aid, which is in the neighborhood of $100 billion. China accounts for a large share of the GFI estimates. But a bunch of hardly-poor oil countries (Kuwait, Saudi Arabia, UAE) are among the top-ten offenders listed -- which probably reflects the difficulty of getting good figures on international oil trade transactions rather than the sums misappropriated.

But even if the estimates are many times too high, IFFs are surely large enough to raise the question of whether stemming them might serve as a substitute for (or supplement to) foreign aid. The argument is straightforward. Assume that government stealing, tax evasion, and other criminal activities continued apace in developing countries, but that international controls were able to prevent the money being transferred overseas. Then, it would at least be available for domestic investment, and could be used to solve a major problem of development -- namely the lack of capital.

Consider, too, that bottling up the illicit funds at home would (ironically) help strengthen the rule of law: If the rich no longer had sanctuaries for their assets overseas, they would have a greater interest in the security of property in their own countries. Perhaps stemming the flow would also reduce predation by rulers. If Mobutu Sese Seko, the longtime absolute ruler of what is now known as the Democratic Republic of the Congo, had been unable to buy villas in Nice, perhaps he would have stolen less -- though one suspects that, after a while, Mobutu's theft became a matter of habit rather than a deliberate decision.

An elaborate, almost universal system of money laundering regulation aimed at just this kind of activity already exists. Every senior government official with access to illicit cash is supposed to be on a list of "politically exposed persons" (as defined by the Wolfsberg Group, an association of 11 global banks), and thus subject to extra scrutiny when they make bank transactions. But the record is spotty: Numerous banks have been caught handling transactions for PEPS that should have stirred the suspicions of even the most oblivious banker.

Raul Salinas, brother of Mexico's president, Carlos Salinas de Gortari, had no problem convincing Citibank to handle $90-100 million in questionable cash in the 1990s. And it took until 2011 for the U.S. government bring a suit against the son of the dictator of oil-soaked Equatorial Guinea, who had purchased a $35 million mansion in Malibu in 2006 while subsisting on a ministerial salary of $100,000 per annum.

The British government's anti-money-laundering controls did enable the Nigerian anti-corruption crusader, Nuhu Ribadu (shown in the photo above, surrounded by his broom-wielding supporters) to enlist the help of Scotland Yard in retrieving $150 million of Sani Abacha's thefts through the UK courts; in total (through many channels), almost $2.3 billion of Abacha's assets were recovered. However this success was an exception, not the rule. Often the difficulty is the failure of successor governments to the kleptocracy to initiate the case. Switzerland held $6 million of the assets of retired tyrant Jean-Claude Duvalier (aka Baby Doc) for years because the Haitian government made no claim against him. In the end, the Swiss changed the law so that they could use the assets to support development projects in Haiti.

Numerous efforts have been made to press developing countries to stem IFFs. However, asking foxes to board up the chicken coops is not a recipe for success. Even if they agreed to put in place the relevant institutional arrangements, a corrupt domestic judiciary could ensure that few cases moved forward. As a banner at a protest rally of lawyers in Africa put it some years ago, "Why rent a lawyer when you can buy a judge?"

One of the attractions of making IFFs a policy target is that the West to clean up its own act in the process of helping poor countries -- tax havens are important to scofflaws in rich countries as well as developing ones. In any event, pressing jurisdictions such as Lichtenstein, the Cayman Islands and Jersey to fulfill their treaty obligations to obtain information about their depositors and to pass on "suspicious activity reports" to other nations seems much more feasible than improving government standards of ethics in Zambia (one more example of a poor nation that fired its first effective anti-corruption director).

So far there has been little movement beyond handwringing. The OECD bureaucracy, which has taken up IFF issue as part of its good governance portfolio, has put the issue on the agenda of its International Tax Conference in June. But, truth is, the subject isn't very high on the agenda of the rich countries -- except for Norway, which is often the good actor on development issues. Probably the best hope for the immediate future is to raise the profile of the IFF problem in developing countries, publicizing who's cheating and who is (or isn't) doing something about it. In the long-run, perhaps, the sheer practicality of stopping these leakages -- the potential benefit from relatively modest efforts -- will generate action from the rich world.

PIUS UTOMI EKPEI/AFP/Getty Images

Argument

Punching Above their Weight

Forget the Big Apple or La La Land. It's Tampa, Phoenix, (and a couple hundred smaller U.S. cities) that are going to power the new U.S. economy.

There's a cliché that young Americans head to the bright lights of the big cities to find their fame and fortune. It's still true, except that those cities aren't necessarily just the big ones anymore. And let's be thankful for that, because it's the U.S. mid-tier cities that are surprisingly generating the growth that will spur the global economy over the next decade.

Collectively, large cities -- which we define as metropolitan areas with a population of 150,000 plus -- in the United States are the center of gravity of the economy, generating almost 85 percent of U.S. gross domestic product (GDP) and nearly 20 percent of global GDP today. While New York and Los Angeles, the two American megacities with populations of more than ten million, have continued to tower above all others among the 259 large U.S. metropolitan areas, it's the 257 "middleweight" cities -- with populations of between 150,000 and 10 million -- that generate more than 70 percent of U.S. GDP today. The top 28 middleweights alone account for more than 35 percent of the nation's GDP.

It is America's large cities, and particularly the broad swath of middleweights, that will be the key to the U.S. recovery and a key contributor to global growth in the next 15 years. Large cities in the United States will contribute more to global growth than the large cities of all other developed countries combined. We expect the collective GDP of these large U.S. cities to rise by almost $5.7 trillion -- generating more than 10 percent of global GDP growth -- by 2025. While New York and Los Angeles together are expected to grow at a compound annual rate of 2.1 percent between 2010 and 2025, the top 30 middleweights (measured by GDP) are expected to outpace them with a growth rate of 2.6 percent.

What is behind the clout of middleweights in the United States? For a start, there are simply more of them than in other developed regions. Of more than 600 middleweight cities around the developed world, the United States is home to 257 of them. East Asia (Japan and South Korea) has 123 and Western Europe 183, both regions with GDP levels comparable to the United States. But it's not just that the United States has more middleweights than other developed regions -- its middleweights also have relatively high per capita GDP. Taking both their number and their relative prosperity into account, U.S. middleweights generate a much higher share of the country's total GDP -- more than 70 percent -- than those, say, in Western Europe, where they contribute just over 50 percent.  

It is the dynamism of American middleweights that is behind their collective strength; but it is the diversity of their performance -- not the similarity -- that is striking.

Although New York, Los Angeles, and Chicago maintained their top three positions between 1978 and 2010, many middleweights among the top 30 cities measured by GDP have undergone considerable change. Five cities dropped out -- New Orleans, Louisiana; Milwaukee, Wisconsin; Columbus, Ohio; Indianapolis, Indiana; and Buffalo, New York -- and were replaced by Riverside, California; Portland, Oregon; Tampa and Orlando in Florida; and Sacramento, California. Within the top 30 there are changes as well: Cleveland, Ohio, for instance, dropped from 17th place to 27th, while Phoenix, Arizona, rose by 15 places, from 28th to 13th.

Overall, differences in population growth explain the most as to why some cities have grown faster than others, rather than differences in per capita GDP growth. Cities that have achieved the strongest economic growth have expanded their populations by two and a half times the rate of the national average. While slowing population growth and mobility will make it harder for U.S. cities to sustain rapid population growth rates, cities that want to grow their GDP will need to pay attention to attracting and supporting expanding populations. Many observers argue that it is the mix of local industries in a city that determines its ability to grow. This is true -- but to a much lesser extent than often assumed. Our analysis suggests that the mix of sectors explains only about one-third of the above-average growth of America's most rapidly growing cities.

Even when narrowing our focus to the strongest performing cities, again there is no single path to success -- no unique blueprint that all urban leaders should pursue. The cities that outperform their peers simply find ways to make the most of the economic opportunities they face, get lucky, or both. Some cities have been able to reinvent themselves; many others make the most of their endowments or their location.

Rapidly growing "gazelles" such as Austin, Texas, and Raleigh, North Carolina, have outperformed the U.S. average in both per capita GDP and population growth by building on their high-tech presence and strong collaboration with local universities. Other cities such as Dallas, Texas, and Atlanta, Georgia -- which we might call "affordable metropolises" -- have outperformed the average national GDP growth because their populations have expanded rapidly (despite per capita GDP growth that was slower than average). These affordable metropolises have managed to offer their citizens a good quality of life at a reasonable price by containing housing costs, for instance. Another set of large, established cities such as Boston, Massachusetts, and Washington, D.C. -- "alpha middleweights" -- outperform others with significantly above-average per capita GDP and sustain moderate growth by leveraging the strength of their existing economic base.

Given this diversity, the key for urban policy makers is to understand their cities' potential and shortcomings so that they can tailor their growth strategy accordingly. Over the past year, Chicago -- a city that, if it were a nation, would have the 20th largest economy in the world -- has undertaken a major effort to compile a fact-based profile of its strengths and weaknesses amid concern that the city's growth has been slowing for the past ten years. Other U.S. cities could emulate Toronto, whose Board of Trade issues an annual report that tracks the city against 24 global metropolitan areas.

Cities need to have a keen ear for what businesses are looking for. Many cities and states across the United States already work hard to attract new businesses. But the competition is intense, not only from emerging markets that have the advantage of lower wages, but also from developed markets where governments are feeling the pressure to do something, to be more proactive in boosting competitiveness and growth. For decades now, Ireland and Singapore have set the bar with their high-performing investment agencies that proactively pursue attractive business opportunities -- "making things happen for investors" to borrow the motto of Singapore's Economic Development Board.

The coming years are not going to be easy. As households and the government pay down debts built up before and during the recession, growth could be dampened for many years. Cities that have experienced real estate booms and busts will find recovery particularly hard going. In Orlando and Phoenix more than half of mortgage holders are in negative equity. In Las Vegas, it's two out of three. And there are still pockets of stubbornly high unemployment -- two-thirds of all the jobs lost during the downturn were in states that accounted for only 45 percent of the U.S. population.

In the longer-term, cities will find it far harder to grow their GDP simply by expanding their populations. The nation's overall population is growing at a slower pace, but aging rapidly. Today, seniors outnumber children in only one of every 20 cities but, by 2025, one-third of cities will have more seniors than children. More worrisome, this demographic trend comes at a time when the mobility of labor, a traditional strength of the U.S. economy, is weakening as the share of young, mobile workers is declining and the share of less mobile dual-income households is increasing. This means that competition for skills is going to be a major issue. Recent MGI analysis has found that there could be a  shortage of up to 1.5 million workers with bachelor's degrees or higher in 2020, while nearly 6 million Americans without a high school diploma are likely to be without a job. Cities with a substantial pool of young and technically educated workers will have the advantage.

The recession has left cities at very different starting positions to cope with future trends. There is little doubt that large shifts in the U.S. and global economy have -- and will continue to have -- a significant impact. The decline of the Iron Belt into the Rust Belt across the middle of the United States as a result of the decline in heavy manufacturing; and the rise of the Sun Belt states are but one illustration of the differing fortunes. But geography is not destiny: There are solutions for both Detroit and Phoenix, for example, to rebuild their economies and continue on the path to GDP growth -- even though the right solutions for each share few similarities.

But the landscape is moving. For example, the shift in the global economic balance to rising emerging nations favors urban centers that are well connected to global growth hubs. Cities with airport hubs and ports, business connections (such as electronics value chains), or personal connections (with universities that attract foreign students) will be in a better position to take advantage of the growing emerging market opportunity.

In this evolving economic picture, the middleweights of urban America need once again to demonstrate their resilience, flexibility, and capacity for reinvention.

“Urban America: U.S. cities in the global economy” was published on April 17 and is available for download at www.mckinsey.com/mgi

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