How does “dirty money” become “clean money”?

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When it comes to drug trafficking, it is rather difficult to get an explanation of the related money laundering aspect. In this interview, former Federal Reserve financial analyst William Bergman offers an explanation. He also points to trouble that he had with the Fed in the past and talks about a suspicious increase of the M1 money supply of the US dollar in July / August 2001.

By Lars Schall

From time to time I cover the topic of drug trafficking – see for example here. Though I received time and again good explanations when it came to the dimensions of the political economy of it, I found it rather difficult to get an explanation of the related money laundering aspect. Here is an interview with William Bergman, a former senior financial market analyst at the Federal Reserve, who has an explanation.

William Bergman has 10 years of experience as a stock market analyst sandwiched around 13 years as an economist and financial markets policy analyst at the Federal Reserve Bank of Chicago. He earned an M.B.A. as well as an M.A. in Public Policy from the University of Chicago in 1990. His research work at the Fed included writing the Chicago Fed contribution to the Federal Reserve “beige book.” Some recent issue areas he has worked on include the implications national emergency and war powers pose for the Federal Reserve, money laundering, and wholesale payment system design, risk, performance and pricing.

L.S.: We hear and read more frequently about banks that launder money from drug traffickers. First of all, why is the cash from drug trafficking of high interest to banks in the financial centers of the West?

W.B.: Cash from drug trafficking, like cash from any illegal activity, is of interest to banks in the West because banks are partners with criminal and other authorities in investigating the proceeds of lawbreaking.  There are a lot of hardworking, honest people in this area, but there are some spectacular alternative examples as well.

L.S.: Has cash from the drug business a magical quality in a profound deflationary evironment?

W.B.: Cash has magical qualities, period, not just in the drug business.  There are two main types of cash – cash on hand, and cash in a bank.  A bird in the hand is worth two in the bush, the saying goes.  We’ve had important public policy developments trying to make cash in a bank equivalent to cash on hand for over a century.  After the Panic of 1907, and a rational panic in that people were running on banks where their money was at risk, the United States developed a new central bank, the Federal Reserve, to try to ensure an ‘elastic currency.’

The Federal Reserve Act arrived in 1913.  But twenty years later we had the worst financial crisis in our history.  This crisis arose in important part because, not despite, the fact that we had a central bank.  The U.S. government then added the Federal Deposit Insurance Corporation to the mix, trying to instill greater confidence that a buck in a bank was worth a buck in the mattress.

The resulting moral hazard and government mismanagement of the advertised safeguards in the system coupled with a wider set of taxpayer guarantees and subsidies that led to the deposit insurance crisis in the 1980s, and in turn, the huge mess that culminated in the financial crisis in 2008-2009.

So, how has cash on hand fared in recent years, relative to cash in the bank?  Amidst all the talk about e-money, and technology, it might be surprising that growth in paper currency (currency in circulation outside of banks, Federal Reserve Notes, and specifically, $100 bills) has accelerated in recent years.  The currency component of M1 has risen nearly 40% since mid-2008, reaching nearly $1.1 trillion.  That’s about $150 for every wallet for every man, woman and child on the planet.   This happened partly because of the loss of confidence in banking systems around the world.

But there could be other factors involved in this increase, in addition to the banking crisis.  For example, shipments of U.S. cash in Afghanistan have been investigated for corruption and other angles by the U.S. Congress in recent years.  On that score, see this report by the GAO, and this recent book by Douglas Wissing titled “Funding the Enemy … .” And with the rising geopolitical risks in the Middle East and Central Asia, it is also worth noting that currency has long played a role in covert operations.  Stephen Kinzer’s book All the Shah’s Men, for example, has a long list of references to the use of currency in operations leading to the overthrow of the Mossedegh regime in Iran in 1953.

To return to your original question, if you are saying we are in a deflationary environment now generally, well, the jury is out on that one, to be sure.   I suppose it depends on what you mean by ‘deflationary environment.’  The price level isn’t falling, at least in the US, which is one definition of inflation.  Many smart people are spooked that inflation is a rising threat due to the extraordinary actions by our central banks and other political authorities in bailing out the banking system in recent years.  But in an environment of depressed banking business, if that is what you are referring to by the word ‘deflationary,’ the relative attractiveness of borderline-illegal banking business may have been on the rise.

And speaking of magic, consider that in the United States we have a law directing 12 magicians to control the total amount of money and credit for over 300 million other people.

L.S.: How important are tax havens for the money laundering process?

W.B.: This is a matter of some debate.  All money havens can be important for the money laundering process – in tax havens as well as taxed jurisdictions.

And all ‘tax havens’ are not created equal.  Some of them are important and respected financial centers with a vested interest in keeping operations, and reputations, clean.  See this, for example.  But again, not all ‘tax havens’ are created equal, and even clean ones can be subject to abuse.  With income tax evasion being one important crime attempted to be hidden by money laundering activity, tax havens certainly deserve their share of scrutiny, at least if you care about the rule of law.

In recent decades, some of the more spectacular money laundering examples have been provided by HSBC, Nugan Hand, BCCI, the Iran-Contra scandal, and Watergate.  In all these cases, important banking services were provided in taxable jurisdictions, not just tax havens.

Speaking of those examples, do you know when the term ‘money laundering’ first entered into common use in the English language?

L.S.: I have no idea.  When was it?

W.B.: When I was first learning about his area, I originally thought it was ties between the mob and laundromats, for example, in the 1920s in Chicago.  Nope.

The Bank Secrecy Act of 1970 is the fundamental anti-money laundering statute in the US.  But looking at the transcripts of hearings leading up that act, you can’t find the word ‘launder.’ And when reviewing editions of the Oxford English Dictionary before 1970, and the word ‘launder,’ you don’t see any references to what we think about as ‘money laundering,’ either  But those senses do show up in the OED definition after the early 1970s.

The use of the term ‘money laundering’ arrived in the US Watergate scandal in the early 1970s.  At least in the sense of ‘cleaning dirty money.’  And in Watergate, money laundering didn’t just depend on tax havens.

But there is another interesting context here.  In 1912, the year before the Fed was created in the Federal Reserve Act of 1913, the Treasury Department introduced new machines around the country.  Currency at the time was partly cloth and partly paper, and the machines would wash the money, and then return it to circulation.  Those machines were actually called “money laundering machines.”

L.S.: Can you explain some basic schemes how money is laundered?

W.B.: The regulators and law enforcement authorities specializing in this area often describe three main aspects to the money laundering process – placement, layering, and integration.  The “placement” process refers to the effort to get ill-gotten gains into legal/respectable banking channels in the first place.  “Layering” refers to efforts to break up larger sums into smaller and otherwise-harder-to-detect-pieces.  “Integration” refers to the end of the process; money is fungible, the saying goes, and a successful money laundering scheme succeeds when dirty money gathers with clean money, and can be used again later.

Regulators and law enforcement authorities have established ways to try to impede the process, at least on the surface. For example, banks and other financial institutions are required to file currency transaction reports in the event of large currency transactions, and suspicious activity reports when criminal or other related activity has good cause to be suspected.

But these reports are not always filed when they should be.  Consider these two examples, for example.  And in light of your question about tax havens above, consider that one of these examples was based in Washington DC.

There are simple as well as sophisticated ways to launder money.   You can do some fancy things in the insurance and reinsurance industries, for example, not just in banks.

L.S.: Is the euro a kind of a competitor of the US dollar because there are higher denomination notes available and so they’re easier to weight?

W.B.: Yes.  To put it simply, using $100 bills, you can put about a million dollars in a briefcase.  With the highest Euro note circulating at 500 Euro, that means you can walk around with 5 million Euro, or about $6 million at today’s exchange rates.  This makes moving lots of money around a little easier.

L.S.: Could the Federal Reserve and its counterparts be doing more on this?

W.B.: Well, one thing the central banks and criminal authorities have considered is using technology to allow satellite and other high-tech tracking of currency movements.  See this, for example.  But they haven’t, at least they haven’t admitted to it, for a few reasons, including the fact that the demand for currency depends in part on the anonymity enjoyed while using it – and not just anonymity desired by criminals.

More fundamentally, of course, you ask an important question.  It’s related to this question:  How often do the authorities look the other way, and help financial institutions doing the dirty work?  Sadly, we have to ask this question, as citizens.

L.S.: Are there some deeper issues here?

W.B.: Yes. To begin to answer this question, I’d like to talk a little bit about my favorite course at the University of Chicago.  It was taught by Sam Peltzman, and titled “Economics of Regulation.”  Peltzman was a big fan of George Stigler, and I really enjoyed learning about Stigler and other folks important in the public choice school of economics like Mancur Olson and James Buchanan and their take on the motives and effects of regulation generally.  As a general rule, special interest groups tend to capture regulatory policy and drive it to their own benefit.  And the producers being regulated are frequently much better-organized then their consumers, leading to the capture of regulatory policy by the firms being regulated.

The financial industry is certainly not an exception in this regard, with well-connected insiders often driving regulatory and bailout policy to their own benefit, at the potential expense of consumers and taxpayers.

While thinking about money laundering, consider it as a form of regulation, one that might be manipulated by forces like this.  What special interest group has the most to gain from trying to manipulate money laundering regulation and law enforcement?  Well, criminals and their money launderers might be in that answer.  Historically, we’ve had examples of law enforcement being captured by criminals.   As citizens, we have a vested interest in seeing to it that law and regulation isn’t bought off in this fashion, but it can happen.

L.S.: The beginning of the end for you at the Federal Reserve came with a proposal in 2003 to strip references to credit ratings from capital regulation as well as a paper of yours that questioned the Fed’s compliance with the Monetary Control Act while pricing Fedwire, a system that moves over a trillion dollars a day among the banks. Why were both things significant?

W.B.: Well, I do think these were both significant contributions, and all they did was get me in hot water.

In the early 1990s, after the S&L and deposit insurance crisis in the United States, Congress passed the Federal Deposit Insurance Improvement Act (FDICIA).  One of the advertised objectives for this legislation was establishing a regime of “prompt corrective action,” and forcing regulators to get into problem situations sooner, and not allowing regulators to allow insolvent “zombie” banks to stay open and gamble for resurrection, at taxpayer expense.

Over time, regulatory policy under FDICIA as well as international cooperative efforts under the Basel regime set up a system including ‘tripwires’ for bank capital levels.  But these tripwires were referencing credit ratings issued by a select few credit rating agencies.  Having read the work of people like Frank Partnoy and Larry White, I became concerned that we were outsourcing our own responsibility and cementing the position of the ratings firms in the marketplace, helping them make money in ways we would ultimately regret.  I tried to catalogue all the ways the Fed was relying on credit ratings in regulations and its own operating practices, and developed a proposal to work to strip references to ratings completely.

In light of the recent meltdown, and the role of the ratings firms in a banking system that proved sorely undercapitalized in the securitization debacle, I think this was a pretty good effort.  But all they did was sneer at me.  More recently, the Dodd-Frank reform law, for all its blemishes, directed the Fed and other banking and securities regulators to do what I was proposing.  Holman Jenkins at the Wall Street Journal has describe this as “one of the rare useful provisions in Dodd-Frank.”

This story matters here more broadly for the main topic you seem to be interested in, particularly in light of what I was describing above, the notion of “capture theory.”  If you are working in the regulatory world, and stand up to the people running the gravy train for vested interests, sadly, there is a tendency for you to get rubbed out.

I think the Fedwire project I did that you mentioned helps illustrate this tendency, too.  A topic for another day, perhaps.  For a short version, see this.

L.S.: Another controversial topic you’re involved with is the increase of the M1 money supply of the US dollar in July / August 2001. When caught your eye and for what reasons?

W.B.: Specifically, the currency component of M1 caught my eye, because while working on a money laundering project in late 2003 I noticed an extraordinarily rapid increase in the data for July / August 2001.

The currency component of M1 is a measure of currency circulating outside of banks.  Recall the distinction between the bird in the hand the birds in the bush, above?  And the difference between cash on hand and cash in a bank?  Well, the currency component of M1 is cash – Federal Reserve Notes – circulating outside of banks.  It can go up because people withdraw cash out of their bank accounts.

As of late 2003, when I was working on this stuff at the Fed, from June to August 2001 this measure (in the non-seasonally adjusted data) posted the largest growth rate for a June to August 2001 since World War II.  In the seasonally-adjusted data (data adjusted for seasonal monthly trends), August 2001 was the third fastest growing single month in the 650+ months since World War II, trailing only December 1999 (Y2K, along with other relevant things) and January 1991 (the onset of US military action in Iraq, as well as an important enforcement month in the BCCI money laundering scandal).

It also seems curious that January 2000 turned up as the fourth fastest growing month, and November 1980 as the fifth fastest growing month, since World War II.

L.S.: Did you ring the alarm?

W.B.: Well not exactly.  But I had also noticed that the Federal Reserve Board had issued a nonroutine supervisory letter to the Reserve Banks on August 2, 2001 urging them to continue to scrutinize suspicious activity reports.  This letter arrived during the surge in currency shipments related to the data above, as well as a spike upward in the number of suspicious activity reports being filed by depository institutions.  Terrorism and its financing were not mentioned specifically in the letter, but they were known to be part of the realm of suspicious activity.

In a draft primer I was writing on money laundering, I asked why the Board issued this letter, and was asked to answer the question.  I called Board staff in a relevant area, asked if it was related to any intelligence warnings of a heightened risk of a terrorist attack, and was planning (in good conscience, not in a “gotcha” sort of way) to talk about the currency shipments and the need to investigate them for relationships to the events of 9/11.

L.S.: What happened to you afterwards?

W.B.: The call was shorter than I expected.  A week later my money laundering assignment was terminated, and I lost my credentials for access to confidential information.  A month later my position in the bank was eliminated.

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One Response to “How does “dirty money” become “clean money”?”

  1. Kevin Ryan sagt:

    Thanks for this informative article.

    It was very much appreciated.

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