Russia’s war in Ukraine may not be going as it had planned, but the worst is still to come. And while Western financial sanctions against Russian institutions and oligarchs have exceeded what some were expecting, they have not targeted the Western-based roots of Russian President Vladimir Putin’s regime.
As in many other kleptocratic regimes, Putin’s power is based on a deal between an autocrat and oligarchs. The autocrat rules the country however he wants and enriches his allies, who make huge fortunes from the country’s natural resources or through regime-sanctioned monopolies.
But there is a catch: As the oligarchs’ coffers grow, they become more concerned about the autocrat’s power to seize their assets or harm their families. They are left with two options. The first is to develop formal and de facto institutions to constrain the autocrat, perhaps even paving the way for much-needed structural reform. The second option is to move their assets and their families abroad, so that they can avoid the fate of Mikhail Khodorkovsky, the leading Russian oligarch whom Putin expropriated and imprisoned in the early 2000s.
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Many Russian oligarchs have availed themselves of the second option, which requires two essential forms of Western assistance. First, the Western banking system needs to provide easy opportunities for them to launder their wealth. London, Switzerland, Luxembourg, Cyprus, Jersey, the Bahamas, and many smaller jurisdictions such as the Cayman Islands have been meeting this demand for years. European banks also have been enthusiastic participants in the process, and the US financial system has provided all of them with the critical infrastructure.
Second, Western financial capitals need to welcome the oligarchs’ families, allowing them to buy property (often via trusts and shell companies) and enroll their children in premier educational institutions. Cities like London and New York have welcomed oligarchs and their kin to the heart of high society.
It is reasonable to assume that Putin’s ability to establish a personalist autocracy would have been substantially curtailed if Russian elites had not had these golden trap doors to the West. But this is not just a Russian story. The superrich in many other countries – including the Gulf petrostates, China, India, Turkey, some Latin American countries, and Ukraine in earlier times – have also secured their illicit gains with the complicity of Western financial institutions and governments.
These arrangements have not only helped to sustain autocratic regimes in Russia and elsewhere. They have also engulfed Western financial institutions and economies. Oligarchs’ money has transformed financial markets by injecting huge amounts of liquidity, thereby changing the nature of financial intermediation and contributing to growing global imbalances. Since 1990, the United States, the United Kingdom, and several other Western countries have run large current-account deficits financed by capital flows from the rest of the world.
After three decades of this, the amount of dark money circulating in the international financial system has reached gargantuan proportions. Gabriel Zucman of the University of California, Berkeley estimates that at least 8% of global financial wealth (more than $7.5 trillion) is now held in tax havens – a figure that does not include the other forms of dark money residing at the heart of the Western financial system. Not surprisingly, autocratic regimes account for a disproportionately large share of these dark-money activities. Zucman finds that some 52% of all household wealth in Russia – and even greater shares in the Gulf states – is held offshore.
These illicit flows have exacerbated social and political problems around the world. The demand for luxury housing has fueled disruptive real-estate booms in hotspots like London, New York, and Vancouver. Because prime real estate in these cities was already predominantly owned by the wealthy, the resulting housing-price inflation has exacerbated inequality. Illicit financial flows probably have contributed to the remarkable boom in Western stock markets in recent years as well, further benefiting the rich.
But the most pernicious effects can be found within Western financial and fiscal institutions. The West’s accommodation of dark money has accelerated the trend toward more opaque ownership structures and complex trusts aimed at evading taxes, supported by a massive infrastructure of bankers, accountants, and lawyers around the world. When Zucman and his colleagues analyzed data from random audits to determine the scale of tax evasion in the US, they concluded that the richest 1% of American households hide more than 20% of their income using the tools provided by this nefarious industry.
Similarly, through the Panama Papers and then the Pandora Papers, the International Consortium of Investigative Journalists has demonstrated that offshore tax evasion is much more systemic and widespread than was commonly believed. Thousands of businesspeople, politicians, and celebrities from around the world have been implicated in what amounts to a global money-laundering operation.
These schemes have left a stain on Western democracies and financial institutions. While the world’s kleptocrats have amassed vast, illegitimate fortunes – and while Western elites have gotten in on the action – Western governments have been unable to generate tax revenues from the rich. As a result, welfare-state institutions and services have been cut back, and existing inequalities have deepened.
Shocked by Putin’s unprovoked war, Western politicians have rushed to support severe trade sanctions, kicking most (but not all) Russian banks out of the SWIFT financial messaging system and freezing the bulk of the Russian central bank’s foreign-exchange holdings. But it will take more courage to clamp down on tax evasion and dark money now that they have become integral features of the current financial system.
Still, if there was ever a moment to change course, this is it. Western policymakers can rein in a tax-evasion scheme that has been unfairly benefiting the world’s most powerful corporations and tycoons for years. In doing so, they can also raise sorely needed tax revenues to support new infrastructure and social programs at home. If the West wants to see itself on the right side of history, targeting Russia is not enough. It must clean out its own Augean stables.
The writer is Professor of Economics at MIT. ©Project Syndicate.
