The U.S. now has one of the most repressed financial markets in the developed world. Financial market repression began with the global ‘Great Deviation’ in monetary policy in the early 2000s. The Fed abandoned a ‘rules based’ monetary policy to hold interest rates far below equilibrium interest rates. This Fed policy of monetary easing was followed by central banks in other G7 countries, and has resulted in great volatility in the money supply in these countries.
Financial market repression has been exacerbated in the U.S. by increased regulations of the banking system that began with Dodd-Frank. More recently the Fed and bank regulators have imposed restrictions on banks engaged in commodity finance. The U.S. is now the only developed country that prohibits the chartering of banks by commercial firms. New restrictions are being placed on foreign direct investment in the U.S. It is not surprising that U.S. banks have pulled back from banking activities subject to increased regulation. The perverse outcome of these regulatory policies has been to decrease competition in the banking industry and increase reliance on the so called ‘too big to fail’ banks. Banks have also become hypersensitive to interest rate risk, and have not expanded lending in response to monetary easing.
In this repressed financial system it is hard to see how banks will finance the increased level of investment required for economic growth and full employment. In order to jump start economic growth the U.S. needs a platform from which both U.S. and foreign banks can allocate financial resources efficiently, independent from the vagaries of Fed policy and overzealous federal regulations.
Fortunately emerging economies have introduced a financial market innovation that could be transplanted to the U.S. Financial free zones, first introduced in the United Arab Emirates (UAE), have experienced rapid growth and proliferation in the emerging economies.
Financial free zones should be distinguished from other types of free zones, such as free trade zones. What distinguishes financial free zones is that entities formed in these zones are exempt from the financial rules and regulations operating in the domestic financial market of that country. Entities in the financial free zone are incorporated by the zone itself independent from the otherwise applicable federal and state incorporation and licensing requirements. Foreign entities do not have to comply with rules regarding local/foreign ownership contained in that countries laws of incorporation, they can be 100% foreign owned. These entities are also exempt from civil and commercial laws in the host country, although criminal laws do apply.
A major advantage of financial free zones is the freedom to transact in any currency without restrictions on the currency transactions. This allows financial institutions to reduce the risk associated with currency devaluation and exchange rate controls. Firms in a financial free zone can use a reference currency that is optimum for their business, they are not subject to currency manipulation and controls imposed by the host country. Interest rates on credit in financial transactions in financial free zones reflect interest rates in world markets. Financial institutions in financial free zones are able to avoid the interest rate controls and central bank interventions used by the host country to manipulate interest rates.
To establish financial free zones in the U.S. Congress would have to create a new administrative and legal framework for financial institutions to operate separate from U.S. banking laws and regulations. The U.S. has a Model Bilateral Investment Treaty that could be amended to incorporate the legal framework for investment in a financial free zone. This model could then be incorporated in free trade agreements with other countries.
For example, the North American Free Trade Agreement (NAFTA) provides a legal framework for financial services between the U.S. Canada, and Mexico. Current provisions of that agreement require both ‘National Treatment’ and ‘Most Favored Nation Treatment’. Essentially financial institutions operating in a foreign country are accorded the same legal treatment as financial institutions in the host country.Creating a financial free zone would require an additional chapter in NAFTA establishing an administrative and legal framework. Since these countries already have a legal framework for financial institutions based on common law and international financial norms it should be straightforward to extend this legal framework to a financial free zone. For the state legislatures to create a financial free zone they would have to restore the freedom and power they once exercised under the constitution to charter and regulate their state banking systems.
A Financial free zone could support the rapidly growing energy sector as well as other industries in North America, much as they have in the UAE and other emerging markets. A financial free zone could be a catalyst for increased investment and renewed economic growth and full employment in the U.S.
Barry Poulson is Senior Fellow in Fiscal Policy at the Independence Institute and Professor Emeritus at the University of Colorado. This op-ed originally appeared at Forbes.com
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