"Overfinance": Iceland, Cyprus...Now Luxembourg?

The modern world has enabled many things to grow far larger than they ought to be through rather unnatural processes. Below is an alleged photo of a 30 pound "goldfish" supposedly caught in a lake in France. I still cannot believe my eyes so many weeks after first seeing this photograph, but if it's real and not Photoshopped, I am truly gobsmacked.

In a similar way, financial crises in Europe are roiling countries whose banking sectors have grown unnaturally large relative to the "real" economy. What does it matter if your financial services industry is unusually large compared to GDP? Well, go ask Iceland from a few years back or Cyprus now. Interestingly enough, the tiny country of Luxembourg which has the highest GDP per capita in the world according to some is being placed in the same category. Despite Luxembourg having an AAA credit rating, however, several European Union members have complained about its status as a low-tax destination alike Lichtenstein or Cyprus. I've even coined a term for the phenomenon that you, dear readers, ought to appreciate: "overfinance."

Now there's another "giant goldfish" sort of complaint going on among EU members that with a similarly outsized financial services sector, Luxembourg is another Cyprus-in-waiting. Luxembourg naturally disdains the comparison--we're a different case, we're special, etc--but the concern is understandable: In one sense it's highly derivative of portfolio theory or that an economy should not put all of its eggs in one basket since, if that industry becomes moribund, it will take the rest of the nation along with it. Hence the usual calls for economic diversification. But still...

As the European Union's wealthiest country, Luxembourg could have been forgiven for thinking that it would never find itself on the bloc's financial risk list. With just half a million people living on a tiny patch of lush land nestled between Belgium, France and Germany, Luxembourg is as tranquil as a buzzing financial center gets. Still, some of Europe's regulators and politicians have started wondering aloud whether its banks might be holding the 17-nation eurozone's next ticking bomb.

Following the chaotic bailout for Cyprus last week, European officials have been drawing worrying comparisons between the two countries' oversized financial industries. Mario Draghi, president of the European Central Bank, cautioned on Thursday that "the recent experience shows that countries where the banking sector is several times bigger than the economy are countries that, on average, have more vulnerabilities." 

"Financial shocks hit these countries stronger, simply because of the size of their banking sector." The increased scrutiny has taken Luxembourg's government by surprise and put it on the defensive. It has rejected calls to shrink its country's main source of wealth to a more manageable size, claiming that its banking industry is much more secure than Cyprus's and any crackdown would not only harm its own economy but that of the wider eurozone...

In comparison, the balance sheets of the banks in Luxembourg have swollen to about 22 times the country's annual economic output of 44 billion euros — making it Europe's richest country per capita. The country is also the world's second-largest center for investment funds, with about 3,800 funds holding assets worth €2.5 trillion ($3.2 trillion) — about 55 times the country's gross domestic product. It has 141 banks based there, with five of them domestic institutions and the remainder being mainly divisions of foreign banks. "There are no parallels between Cyprus and Luxembourg, and we don't allow any parallels to be forced on us," Prime Minister Jean-Claude Juncker said last week. "Cyprus is a special case; other financial hubs in Europe don't have these problems."

Just as the UK keeps complaining that the EU is trying to suffocate its financial services industry, so does Luxembourg:

Stung by the comparison with Cyprus and concerned for the future of its banking industry, Luxembourg's leaders have begun to fight back. They have accused EU officials, and Germany in particular, of bullying smaller countries and seeking to "strangulate" its financial industry — which represents 27 percent of the country's annual economic output, a third of the tax revenues and employs 20 percent of the workforce. German Finance Minister Wolfgang Schaeuble, representing Europe's biggest economy, openly wondered last month whether a business model relying too heavily on banks can still be seen as viable after the Cyprus debacle. That immediately prompted an outcry in Luxembourg.

"Germany does not have the right to define the business models for other countries in the EU," said Foreign Minister Jean Asselborn. Luxembourg's government says its financial sector "acts as an important gateway for the euro area by attracting investments, thus enhancing the eurozone's competitiveness as a whole while being effectively supervised".

The government rejects the idea of looking at the size of its financial sector only in relation to its GDP. "What matters are primarily two aspects: while the first aspect touches on the quality and solidity of the financial sector, the second element relates the size of the financial sector not to a national economy but to the euro area or single market as a whole," it said.

And there is still lingering resentment about how Luxembour's financial services industry grew so large in the first place. Call it "overfinance" meets "giant goldfish":

The success of Luxembourg's financial sector was initially fueled by lax regulation, secrecy and low taxes. This made it a popular tax haven and money-laundering spot. The country later changed many of its laws following pressure by its European partners. But critics say the financial industry still lacks the necessary transparency.

"The name Luxembourg always comes up when companies try to move profits across borders, through the so-called aggressive tax planning, to avoid paying taxes," said the president of the German tax inspectors' association, Thomas Eigenthaler. "It lacks transparency and quite often there's nothing we can do about it." Luxembourg rejects those charges and says it complies with all relevant laws. But on that front too, the pressure is increasing. 

In the wake of the publication of details on wealthy people's offshore bank accounts by several international media this week, some of which included references to shell companies based in Luxembourg, Frieden is now signaling the country's willingness to agree for the first time to automated information exchanges with other countries' tax authorities. "Unlike in the past, we no longer strictly reject that idea. We want a strengthened cooperation with the foreign tax authorities," he was quoted as telling Germany's FAS newspaper. 

Tax cheaters never win, eh?