Financial Transparency Coalition

In the last few years—and particularly since Vladamir Putin retook power—Russia has increasingly retreated to Cold War tendencies. Russia’s relationship with the United States has soured over its ban on American adoptions of Russian children, a clash over its missile defense problem, and USAID’s democracy promotion efforts. This week, in perhaps the most obvious flashback of all, President Putin announced his nation requires an immediate and massive military upgrade by 2016. And the former KGB agent plans to spend $750 billion over the next seven years to accomplish it.

Yet Russia’s existential threat is not from the United States. No, that threat comes from within.

Two weeks ago, Global Financial Integrity released a report on illicit financial flows from Russia. In the report, authors Dev Kar and Sarah Freitas detail the cross-border flow of illicit funds to and from Russia over the period 1994 to 2011. Usually, I would focus on the illicit outflow component of the report. Yet in this case, I think there is another interesting story to tell—and that’s about the inflows.

Illicit inflows to Russia ranged from a low of $11.1 billion in 1994 to a high of $80.6 billion in 2007. In 2011 they were $58.7 billion. As the report points out, there is no reason to believe “that money brought into a developing country through illicit channels will be declared as taxable income or can be used for economic development” because an investor has no incentive to smuggle in capital from abroad if it represents a genuine return of funds. In fact, rather than adding to a productive capacity, that money can “drive a speculative real estate boom, create a housing bubble and push the country towards economic instability.”

But I’d take it a step farther.

Illicit inflows in different contexts have wildly different implications. In the Russian experience, where corruption is widespread and the informal and underground economies represent a significant portion of economic activity, illicit inflows are likely contributing to the black market. In other countries, they might be indicative of a low tax rate, an opaque financial sector, or both. Yet as a source of funds for criminals, illicit inflows to Russia likely are not only indicative of a black market—but a driver of one.

There’s one way we could investigate this further, based on an approach already in the report. In the report, Kar and Freitas correlate total illicit flows (outflows plus inflows) with a model of an underground economy developed by Vito Tanzi, an IMF economist and former associate at the Carnegie Endowment for Peace. Tanzi’s model is one of the best—but certainly not the only—measure of what is generally immeasurable: an underground economy. There are a lot of intricacies to his model, but what you need to know is that Tanzi explicitly considers tax evasion in his measure. That is entirely appropriate, but it has significant implications in the Russian context—particularly when considering inflows versus outflows.

In the report, Kar and Freitas find a positive correlation between total illicit financial flows and Tanzi’s measure of an underground economy. While this is an interesting finding, I’d be interested to see a broader set of correlations, with a variety of measures of the undergrounded economy and with illicit inflows and outflows modeled as explanatory variables on their own.[1]

You see, my hypothesis is that other measures of an underground economy would be more or less strongly correlated with illicit inflows than outflows, depending on what they measure. Context is important, but inherently I believe illicit outflows indicate different types of underground activity. For example, Schnieder and Enste (2002) have suggested a model of an underground economy measured based on informal sector activities, which are not part of national income accounting. As such, the underground economy is defined by a more narrow range of criminal activities, which, in the case of Russia, may be more relevant.

In particular, while both inflows and outflows may be indicators of political and economic instability and, therefore, indirectly related to the Russian underground economy, I would posit that one can draw a straighter line between illicit inflows and the type of underground economy characterized by the Russian experience. As a result, I’d be interested to see each inflows correlated with the Schnieder and Enste model, with outflows alone mapped against Tanzi.