How GDP masks the finance curse

Every country needs a financial centre, but as it grows beyond a certain optimal size (where it is carrying out the functions it is supposed to do) it starts to harm the country that hosts it. That is the finance curse, and many countries including the United States and United Kingdom passed that point decades ago. Shrinking the financial centres in these countries (in the right way) would make their citizens better off.

The finance curse is a compex phenomenon — see this explainer — but one of the commonest objections to it goes like this: “if oversized finance is so harmful, how come Switzerland and Luxembourg and Bermuda are so rich?”

At first glance, this question seems to be reinforced by an extensive new World Bank report, with the thrilling title “Purchasing Power Parities and the Size of World Economies.”

It noted that Luxembourg, a tax haven, had the world’s highest Gross Domestic Product (GDP) per capita, at $112,000 (on a Purchasing Power Parity basis, which is the most normally used measure of GDP,) with Ireland and Switzerland at a still-impressive $78,000 and $67,000 respectably. These tax haven scores are comfortably above those of other European countries: Denmark ($55,000), Finland ($47,000) France (45,000;) Germany (53,000;) Netherlands ($55,000;) Norway ($63,000,) Sweden ($53,000) and the United Kingdom ($46,000.)

Perhaps the headline from that comparison is that Luxembourg’s GDP per capita is twice that of Germany.

Case closed? Not so fast.

The Financial Times is also looking at this report, under a headline “Why the world’s richest countries are not all rich.” And it explains what most economists know: GDP is a pretty poor measure of the prosperity of a country’s citizens. In this case, that’s because GDP includes corporate profits — and when you’re a tax haven, those profits hardly touch the sides. They are measured in the data, but hardly contribute at all to citizens’ wellbeing (and as the finance curse explains, they often detract from it.)

This table from the World Bank report highlights the problem:

The light blue bar shows GDP per capita, making the tax havens look great; the smaller dark bars show AIC (Actual Individual Consumption per capita) where Switzerland, Luxembourg and Ireland look rather pedestrian. The finance curse disappears. (Bermuda’s AIC is pretty high – but we’ve been looking at Bermuda recently and its tiny population — the section that hasn’t already fled economic distress — is severely divided with a large share suffering severe hardship, and the main winners being white expatriates.)

Luxembourg’s Actual Income Per Capita is $38,000, somewhat higher than Germany’s $34,000, but not crazily so. Switzerland’s is $35,000, while Ireland’s is $27,000. The other rich countries — Denmark, Finland, France, Netherlands, Norway, Sweden, the United Kingdom — all have AICs from $31-36,000.

Not only that, but there is a range of other reasons, nothing to do with tax havenry, which boost ehe genuine incomes per capita of the havens. Over two thirds of the economically active population of Luxembourg, for instance, are foreigners, many commuting in on an daily basis: so other countries pay for these people’s education and retirement, and Luxembourg takes the cream of their productive working lives. Ireland — well, Ireland’s “Celtic Tiger” economy is not only not what it seems (once you change GDP into more appropriate measures like Gross National Income) but the widely peddled story that corporate tax cuts made Ireland a myth is a hoax. The ingredients of success were elsewhere entirely (look at this, if you don’t believe us.)

What is more, countries dominated by large offshore financial sectors tend to have economic policy captured by financial interests, which tends to create regressive policy (tax cuts for the rich, anyone?) which worsen inequality: neither GDP nor AIC per capita capture these nuances.

In short, debasing your economy, relaxing tax laws and financial regulations to attract the world’s hot money, is no recipe for national prosperity.

Don’t believe the hype. Don’t fall for the finance curse.