POWER PLAY OF DRUG MONEY IN AN ECONOMIC CRISIS
Money laundering is the process of converting black money received from unlawful means such as drug trafficking, theft, corruption, embezzlement, etc. into white money by hiding the source of the said funds. The banking system is considered one of the most efficient platforms to transform black money into legitimate money. However, since banks are subjected to strict rules, this seems easier said than done. But what if banks decide to overlook these regulations because they are in a desperate need of this cash? In a time of economic crisis, wherein the nation’s economy is on a continuous decline as a direct result of a financial crisis, this scenario may not be purely hypothetical.
The 2008 Crisis
“The seeds of the financial crisis were planted during years of rock-bottom interest rates and loose lending standards that fuelled a housing price bubble in the U.S. and elsewhere.”
It all started when people took advantage of low mortgage rates and as house prices rose it led to greater demand for loans. To keep up with the demand the banks increased the supply for these loans by loosening the kind of people they offered mortgages to. Now, people with bad credit could also take loans.
Banks eventually sold these loans to other investment banks, which then converted them into debatable “low-risk” financial instruments such as mortgage-backed securities. Moreover, to inculcate greater risk-taking among banks, the SEC in October 2004 eased the net capital requirements for some investment banks among which were the Lehman Brothers and Bear Stearns. This lets them leverage their initial investment to 30 or 40 times.
But, the trouble started brewing when in early 2006 house prices started to drop. The reason behind this was that people started to default on their repayments and seeing this the banks started to sell more houses which led to an increase in the supply of houses and further the prices of houses plummeted.
One by one many subprime lenders started to file for bankruptcy, to think that the company which made nearly $60 billion in loans in 2006, in 2007 filed for bankruptcy protection. And in September 2008 Lehman Brothers collapsed in the biggest U.S. bankruptcy ever ( $613 billion in total debts as of May 31, 2008). Financial institutions were now stuck with trillions of dollars of subprime mortgages that were nearly worthless.
How drug money successfully penetrated the money supply
In 2007 and 2008, the drug trade and housing market both saw rapid growth. The drug gangs, which previously stored their funds in cash or offshore accounts, embarked on a buying spree of assets. They broke up enormous sums of narcotics money into smaller quantities and transported them into nations with laxer anti-laundering regulations. Normally, this would generate a lot of interest, and authorities would investigate.
But in 2008, when banks were in dire straits, they disregarded this unexpected infusion of $ 352 billion, which equals to around 22 tonnes of cocaine, to pull themselves out of a near-collapse situation. Banks received huge sums of money as a result, and drug gangs were able to effectively clean up their dirty cash by gaining unhindered access to the financial system.
Although these claims were backed by Antonio Maria Costa, the former head of the U.N. Office of Drugs and Crime, they were unable to determine the extent to which drug money contributed to the economy's recovery. Whilst it did inject liquidity into the economy, it would be presumptive of us to state that this was sufficient for banks to meet their needs for daily operations and interbank loans. This would have been impossible without government intervention.
The balance sheet of the US Federal Reserve quickly grew in 2008. The federal bank added $1.3 trillion to its assets between September and November.
The amount of money from just that is 3.7 times greater than the $352 billion from the drug trade.
According to a Government Accountability Office report in 2011, federal banks gave loans worth more than $1 trillion to banks to ease liquidity problems in 2008. In order to reduce perceived risk on banks' balance sheets, the U.S. government made significant purchases of mortgage-backed securities in 2009, many of which were deemed toxic at the time.
Criminal Finance in other economies
Similar to what happened in the United States, criminal finance acted in the form of black money that was disseminated through a parallel economy in the real estate market, to mitigate the impact of the crisis in India.
In India, cash is used for the majority of practically all home purchases. The vendor is likely to accept a portion of the money as official payment and seek the remaining amount in cash. This payment made in cash is called black money.
It indicates that the seller can save money on capital gains taxes. The reported valuation of the property affects how much property tax buyers must pay; the lower the declared value, the lower the tax. It also implies that, compared to other countries, Indians typically have mortgages that are significantly less relative to the actual worth of their homes.
As a result, when property values in India fell in 2008 and 2009, the majority of bank loans were still far below the value of the property. As a result, it considerably lessened the negative effects of the real estate market collapse on the Indian economy.
Another major country benefiting from criminal finance is Columbia. The Colombian government issued treasury securities, which were then sold to Colombian investors and informed sources reported that some securities were purchased with drug money and since there were no laws regarding money laundering in Columbia at that time the government as well didn’t take into much consideration where the money was coming from.
The security offerings provided the Government to pay for its multilateral loan payments and its total foreign debt was reduced by about $464 million in 1993, while the total payments through the external debt account amounted to $585.5 million. Ironically, a large percentage of the foreign currency reserves that are flooding the Colombian Government's international reserves accounts were believed to have taken root from the repatriation of drug proceeds from U.S. and European drug markets. The revenue generated by the influx of drug proceeds into the economy has provided the Colombian Government with funds for debt payments and national infrastructure development. Furthermore, through the purchase of government-issued securities, Colombian drug kingpins were investing in their country's future economic development.
The Government authorities have evidence of drug proceeds being deposited in every major bank in Colombia. It was indicated that many banks and businesses were owned covertly by principal members of the Cali Cartel. Moreover, suspicions were raised when a major Colombian bank was sold to a wealthy Colombian family said to be associated with a major Colombian drug cartel for a price 15 percent above government expectations.
Economic vs Moral Point of View
There are nations where the proceeds from drug sales account for a sizable portion of the national economy and lead to a growth in the GDP which is why drug money may prove to be beneficial from a purely economic sense.
A cash injection can help a nation's reserves and reduce its foreign debt in times of low liquidity. The fact that a significant portion of the drug trade is conducted in cash makes emergency cash readily available. As a result, it might be seen as a potentially stabilising force and a source of funding without the string of conditions attached.
Moreover, an increase in the money supply is usually accompanied by a rise in investment for the development of infrastructure which in turn leads to generation of employment.
However injection of drug money into the economy in the long run can lead to major inflation in the country leading to a decrease in the value of the currency as well as the concentration of power is also with a limited number of people. Furthermore, the opportunity cost of drug trade includes the government losing a large amount of tax revenue. It establishes a covert system that operates outside of established channels, making it impossible for the government to regulate.
Moreover, one cannot disregard its impact on society. Promoting drug money as a source of liquidity would only help support cartels and extremist organisations, which would in turn fuel more criminal activity including the sale of firearms, drug and sex trafficking, terrorism, etc.
Furthermore, it impairs the physical and mental well-being of society in the way of having to live in a place crawling with offenders and people carrying weapons, always having to live in fear for their lives and not being able to raise their voices against this oppression, which lowers their productivity and raises the risk of violent crime. Reduced tax revenue would also mean fewer programmes and resources for the less fortunate in society, widening the income gap.
Another point to add is the power concentration ,i.e., this drug money supply only benefits a few select communities of a country until and unless they themselves decide to invest in the infrastructure of the country; all the decision-making stays in the hands of drug cartels and not even the government.
To conclude, drug money in the economy definitely helps in times of economic crises by adding to the liquidity of the economy. However, it is not beneficial in the long run. We have already covered the economic and moral aspects of how drug money affects an economy which revolves around an increase in GDP, inflation, injection in money supply and power concentration as well as increased criminal offences, violent crimes, detrimental impacts on the physical and mental well being of the general public among others.
Mahi Rawat is a Junior Analyst at IFSA Hansraj
Manvi Gupta is a Junior Analyst at IFSA Hansraj
SEC - U.S. Securities and Exchange Commission
FRED - Federal Reserve Economic Data
GDP - Gross Domestic Product
Offshore accounts - These accounts are identified as those which any business or individual has outside the country of residence.
Capital gains tax - The tax that is levied on capital gains like profit on sale of investments held for more than one year.
Property tax - A tax that is paid on the property owned by any individual or any other legal entity.
Mortgage - A mortgage is a legal agreement between a debtor and a lender that gives the lender the right to take debtor’s property if he/she fails to repay the money they've borrowed plus interest.
Mortgage-backed securities - These consist of a bundle of home loans and other real estate debt bought from the banks that issued them and the investors receive periodic payments.
Treasury securities - They are the debt obligations issued by the Government of a country and are backed by the full faith and credit of the government.
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