Capitalism as Crime Prevention

Capital controls spur black markets and murder rates

Manipulating the flow of capital can lead to the mafia culture expanding and contaminating their economies.

Policymakers around the world have responded to the recent global financial crisis by implementing new economic measures that reverse a four-decade-old liberalization trend.

This new permissiveness towards economic controls that measure capital and currency restrictions, capping interest rates, and imposing import and export licenses, are finding their way back into the policy toolkit.

Though occasionally effective, these measures can be overused. And aside from economic arguments against restrictions, history shows a seamy side effect to governments manipulating the free flow of currency and goods – black market violence.

Kislaya Prasad, professor and director of the Smith School’s Center for International Business Education and Research, investigated this phenomenon through India's recent history. His findings link a declining rate in homicides to that government's 1991 transition to a free market economy that involved a dramatic loosening of controls on trade, manufacturing and currency.

Prasad analyzed India’s intentional homicide rate and its dependence on the differential between the Mumbai and London price of gold. Prior to 1991 the import of gold into India was heavily restricted, creating a divergence between Indian and international gold prices. This differential – a measure of the attractiveness of smuggling – is found to predict changes in the homicide rate. Liberalization caused the gold price differential to decline and this dramatically affected the homicide rate. After rising steadily through the 1980’s, the murder rate declined sharply after the initiation of reforms.

“A variety of social institutions – courts of law for instance – have been devised to manage conflict between agents engaged in trade,” Prasad explains. “When a transaction becomes illegal people lose access to such institutions and end up resolving conflicts through violence. Rationing leads to black markets, tariffs lead to smuggling, and disputes among black marketers and smugglers are settled – often violently – outside the courts. Liberalization in India had the effect of putting a lot of black marketers and smugglers out of business.”

Prasad expanded the study to 100-plus countries. Analyzing two decades of data, he shows restrictions on trade—measured in a variety of ways, including using the black market exchange premium—are associated with a lower homicide rate across those countries.

Prasad says his research was inspired by Edward Luce’s “In Spite of the Gods: The Strange Rise of Modern India” (Doubleday, 2007), which tells the story of India’s free market transformation from “license Raj” – a system in which “you couldn’t hire, fire, change the size of your labor force or build an extension to a plant without first securing a government license,” he says. The controls extended to imports and exports, which made it very lucrative to smuggle not just precious metal, but also alcohol, electronics, and industrial inputs like polyester filament yarn. These factors created an environment in India analogous to the alcohol prohibition era in U.S. history. “Similar to Al Capone’s notoriety in American folklore of that era, the likes of Haji Mustan and Chhota Rajan became wealthy and infamous as Indian gangsters, largely through gold smuggling.”

The organized crime culture is discussed in Luce’s book, which includes remarks by an Indian police officer that provided the spark for Prasad’s study: “The mafia dons were making most of their money from smuggling gold and electronic goods. Since the 1990’s restrictions have been lifted so there is much less money to be made in smuggling. They still have protection rackets and prostitution rings, but these are not as lucrative … Ten years ago we would have two or three gang killings every day. Now it is a few each month.”

Prasad says lessons of his research for policymakers will be apparent. “Criminalizing transactions that people seek to engage in is rarely a good idea, especially now as governments around the world are tempted to institute new economic controls.”

The takeaway for executives is more subtle, he adds. Any business transaction potentially brings disagreement and conflict. But unlike smaller and perhaps homegrown companies in developing markets, foreign companies tend to be insulated from black market crime.

Firms with sufficient capital can access “an emergent and thriving dispute resolution industry of third-party mediators and private, judicial arbitrators in countries with weak public legal infrastructures,” says Prasad. These companies still must prepare to use these private sector dispute resolution mechanisms, just as they would the public court system, to better manage contract disputes.

Prasad’s findings could also generate further investigation into the relationship between other forms of control and violent crime. “Mexico’s tightened control on the drug trade has coincided, and likely correlates with, a striking rise in crime in the last three-to-five years,” he says. “But whether to lift controls on an addictive commodity is a much more difficult and complex question compared to loosening restrictions on trade.”

“Economic Liberalization and Violent Crime,” is forthcoming in the Journal of Law and Economics. For more information, contact kprasad@rhsmith.umd.edu.