–Chris Matthews, April 1, on the record 2009 salaries of hedge-fund executives

And what kind of society pays Chris Matthews all that money say totally ignorant things on television every night? (I’m assuming I don’t have to comment on Matthews’s premise that “society gives” money to hedge-fund managers.)

For some actual information on the subject, see Warren Gibson’s Freeman article “The Mystique of Hedge Funds.” Here’s a teaser:

As long as there is no fraud, hedge funds, like other market participants, produce social benefits. They provide market liquidity, the lubrication that makes markets work well. Successful funds help move capital to where it is most needed and help move prices in anticipation of future events. Unsuccessful funds go out of business sooner or later, and investors in failed funds learn to be more careful about whom they select to handle their money.

What is a hedge fund? The name implies hedging, a strategy that reduces risk. If you bet on several horses in a race, you are hedging your bets—spreading your risk. You can buy gold to hedge against inflation. You can sell interest-rate futures to hedge the risk that rising interest rates would pose to your bond portfolio.

The first hedge fund was created in 1949 by Alfred Jones. He believed he could pick stocks that would outperform and those that would underperform the overall market. But Jones didn’t know where the overall market was going, so he would buy his expected outperformers and sell short the expected underperformers. He thereby insulated his portfolio from general market moves, which would affect about half his holding positively and half negatively.

Most present-day hedge funds don’t do much hedging, but the name persists. Instead, they engage in a bewildering variety of trading methods, including buying on margin (using borrowed funds) and selling short (selling borrowed assets so as to profit from a price drop). They trade stocks, bonds, options, currencies, commodity futures, and sophisticated derivatives thereof. Some try to anticipate global political or economic events, while others seek opportunities in specific industries or companies.

Hedge funds are like mutual funds in some ways. A mutual fund sells shares to investors and uses the proceeds to buy stocks or bonds (usually). A fund’s income and realized capital gains are distributed to shareholders, while unrealized capital gains are reflected in higher mutual fund share prices. Like mutual funds, hedge funds are typically open-ended, meaning they can sell shares to new investors from time to time or repurchase them from existing shareholders.

There the resemblance ends. Anyone can buy mutual fund shares, but hedge fund shares are generally available only to “qualified investors,” defined by an annual income of at least $200,000 and financial assets of $1,000,000. Withdrawals of capital are only permitted at limited times. Shares cannot be offered or advertised to the general public, which can be an advantage because it may make investors feel that they are gaining entrée into an exclusive club.

Hedge fund managers are more lightly regulated than mutual fund managers. They are allowed to charge performance-based fees, for example, which is forbidden to mutual fund managers. Though management fees vary widely, hedge fund managers typically retain 20 percent of any gains. This gives them some “skin in the game,” which presumably motivates them to do well for their investors. However, they do not share in fund losses. Hedge funds typically charge short-term redemption fees to discourage short-term trading and maintain a stable asset base.

Perhaps the biggest difference between the two fund classes is that hedge funds are free to take very large risks, while mutual fund managers are constrained against “excessive” risk-taking.

Stupidity in the Hedge Fund Business

Long Term Capital Management (LTCM) was a hedge fund that collapsed in spectacular fashion in 1998. The immediate cause was the Russian bond default, but, more fundamentally, LTCM relied too much on sophisticated computer models and extreme use of leverage, meaning almost all its capital was borrowed. When the Russian government defaulted on its bonds, it set off a chain of events that LTCM’s models had indicated was essentially impossible. These events produced huge losses that took the fund to the brink of default, threatening big losses for its lenders, including some of the largest and most influential New York banks. So the Federal Reserve Bank of New York came to the rescue, arranging a $3.6 billion bailout, a sum that seems quaint by today’s bailout standards. The same “systemic risk” argument that we hear today went around then: A default on those loans, it was said, would be an intolerable shock to the financial system. “Too big to fail” was the reason; “too well-connected” was perhaps more accurate.

Even though the fund eventually recovered without losses to the bailout guarantors, the LTCM failure represents a missed—and golden—opportunity. Had the fund been allowed to fail, and had the big banks taken their losses, it would have struck some well-deserved fear into the hearts of fund managers, investors, and especially bankers. Our current financial crisis might have been less severe as a result. LTCM was very secretive about its strategies, and the bankers who loaned money to the fund likely knew next to nothing about what LTCM was doing with it until it was too late. They were awestruck by the reputations of the LTCM partners, two of whom had shared the 1997 Nobel Prize in economics. Had LTCM been allowed to go under, its example would have tempered risky behavior by others. If uninsured depositors at these banks had also lost money, they too would have gotten a valuable wakeup call. Instead, a brick was added to the house that came to be called the “Greenspan put.” It said: Go ahead and take risks. If you win you collect the profits. If you lose, we’ll cover you.

Hedge Funds: Bane or Boon?

Is it wise to take high risks as hedge funds do? For most people, no. For those whose resources are large enough that they can afford to lose some capital and who enjoy the thrill of the chase, perhaps yes. We all have different temperaments and different circumstances. A free society respects these differences and does not stop its members from taking risks nor shield them from the consequences.

As long as there is no fraud, hedge funds, like other market participants, produce social benefits. They provide market liquidity, the lubrication that makes markets work well. Successful funds help move capital to where it is most needed and help move prices in anticipation of future events. Unsuccessful funds go out of business sooner or later, and investors in failed funds learn to be more careful about whom they select to handle their money.

But regulation brings unintended consequences, many of them harmful to the people they are supposed to protect. Absent regulation, it is unlikely there would be a separate category called hedge funds, distinct from mutual funds.

Unfortunately, in January the President’s Economic Recovery Advisory Board, headed by Paul Volcker, called for registration of hedge funds and public disclosure of their holdings. Fund managers will likely resist disclosure, which can damage their mystique and invite free riders. The board report addressed not only hedge funds but also any other “systemically significant” financial institution of any type, and the criteria by which systemic significance is to be judged were left vague.  To their credit the board members recognized that “a modest system of registration and regulation can create a false impression of lower investment risk.”

The Hedge Fund Transparency Act (Senate Bill 344) was introduced shortly after the report was released. It has been in committee ever since. It would cover private equity funds and venture capital funds along with hedge funds.

Market participants will very likely find ways to get around any new regulation or to co-opt it, as they generally do.

Regulation: Rationale and Reality

Business regulation almost invariably starts with wide popular support. Most people assume big business must be restrained lest it run roughshod over the little guy. But often, as in the Progressive Era a century ago, it is big business that actually promotes regulation, expecting it to put smaller competitors or would-be competitors at a disadvantage. Often regulators start out conscientiously dedicated to their jobs, but over time familiarity can transform them into advocates for those they regulate. Hedge fund regulation is no different.

Why are people of modest means forbidden to buy hedge fund shares? The presumption is that they lack the knowledge and sophistication necessary for intelligent risk-taking. Common folk must be protected from themselves, lest they get in over their heads. After all, we can’t have people gambling their rent money. (Unless, of course, they’re gambling on state lottery tickets.) The regulation that was supposed to protect small investors actually protects large investors by locking out their smaller competition.

The prohibition on advertising by hedge funds (or other “private placements”) blocks potentially useful information. It is harder for managers and investors to find each other when important information is, in effect, censored. Middlemen, such as financial planners or trust officers, are left to fill the gap, which they do relatively inefficiently.

The rule forbidding mutual fund managers to charge performance-based fees again hurts the little guy by denying access to performance-motivated managers. It also drives up the fees that hedge fund managers can charge by shielding them from mutual fund competition in this respect. Thus both hedge fund investors and mutual fund investors come out on the short end of this regulation.

Regulators sometimes fail to catch the bad guys—see the Bernard Madoff case—but they sometimes destroy good guys as well. Art Samberg has enjoyed a long career as a successful stock-picker. By 2001 he and a colleague had built Pequot Capital Management into the largest hedge fund in the world, riding the technology wave up and later shorting it on the way down. In 2001 the Securities and Exchange Commission began investigating the firm for insider trading, but no charges were ever filed and Samberg strenuously denies any wrong-doing. Guilty or not, by last May the bad publicity had taken such a toll that Samberg announced he would shortly liquidate his fund—sell all its holdings and return cash to the shareholders. (Whether insider trading is something that should really be forbidden is a subject for another time.)

Regulation has many other drawbacks. But a badly neglected one is that government-imposed minimum standards tend to become maximum standards. People take less care to understand what they’re getting into with a regulated investment because they assume that regulators have diligently vetted the offerings. All firms getting a pass from the regulators tend to be treated alike. That’s when trouble begins.

“The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing ‘imperfect’ institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements.”

A common form of the fallacy is rejection of the imperfect free (or freer) market in favor of (presumably) omniscient, omnipotent, and omnibenevolent government regulation. A “flawed” but achievable arrangement is set against an (alleged) ideal, though it is left unestablished whether the ideal can in fact exist. The problem here should be obvious. If the ideal is not available, then the comparison is worthless. If the rejected option were compared to other achievable—also imperfect—alternatives, it might well be judged superior.

A recent example of the Nirvana Fallacy comes from Sen. Charles Schumer of New York. Asked how the Obama administration will prevent another financial crisis, Schumer said:

“You’re gonna find a different system of regulation. . . . So like when Bear Stearns began to run into trouble, they’re gonna call the heads of Bear Stearns in and say, ‘All right fellas, you’re getting rid of those two hedge funds; you’re gonna raise more capital—even if it means you have lower profitability. . . . [Y]ou do it or we’re gonna take sanctions against you.’ . . . You need a tough, strong regulator, unified—no holes in the system— . . . who . . . sees the problem ahead of time, so they have complete transparency, they know exactly what’s going on. . . .” (emphasis added)

We see at once that Schumer assumes what he must demonstrate: namely, that the regulator can overcome the Hayekian “knowledge problem,” the limits posed by the fact that the most critical economic information is not readily obtainable statistical data but rather is diffused and often unarticulated knowledge, including know-how.

Look at what I’ve highlighted in his statement, and ask yourself what Schumer apparently has not asked himself: How will the regulators “know exactly what’s going on”? Spotting Bear Stearns’s specific hedge-fund problems “ahead of time” would have required insights and hunches that only entrepreneurs with money at risk could be expected to have—and even those might not have been enough. Fortune-telling is not a widely distributed skill. It’s not a matter of toughness or access to Bear’s books but, at the very least, of entrepreneurship (not to mention luck), which is profit driven. Bureaucratic regulators bring no such talent to their jobs. More likely, they’d be enforcing formal (possibly outdated and irrelevant) rules, looking for a repeat of the last problem, while missing the next one entirely. As Nassim Nicholas Taleb might say, it’s the next black swan, not the last one, that bites you.

Schumer’s fallacy is actually worse than the standard Nirvana Fallacy. He doesn’t compare his unrealizable regulatory vision to the free market but rather to our corporatist economy replete with government bailouts, moral hazard, easy credit, and all the other ways of disabling market forces.

The closest we can get to what Schumer says he wants is through the discipline—that is, the regulation—imposed by the unfettered market. That includes bankruptcy’s Sword of Damocles and the freedom of traders to sell short—that is, to profit by betting that a company’s stock is overvalued and communicating that information to the market early. Predictably, the government is planning to restrict short selling. Bad regulation drives out good.

* * *

Advocates of big government claim they learned lots of lessons from the New Deal. But here’s something they missed: The post-1929 economy began to rebound before FDR’s programs could have taken effect and even before he took office. Jim Powell explains.

Government spending is said to be indispensable to recovery from a recession thanks to the magic of the “multiplier.” Is there really more bang from the government-directed buck? James Ahiakpor debunks the myth.

But surely the government is good at creating productive jobs when it spends money, no? Larissa Price, applying Bastiat’s lesson, throws cold water on that hope.

By now you may have bought some of those funny-looking spirally light bulbs after hearing they use less energy and save you money—only to find that they can’t hold a candle to the old incandescent bulbs. Thanks to Congress and former President George W. Bush, though, soon you won’t have a choice. Michael Heberling has the unfortunate details.

Last spring’s G-20 economic meeting called for a crusade against tax havens, places where people can protect their wealth from greedy politicians. Daniel Mitchell comes to their defense.

Can there be freedom when the state sees itself as Robin Hood? Carlos Rodríguez Braun shoots an arrow into the heart of that belief.

Land has been at the center of conflict from time immemorial. Even so-called capitalist countries have been blemished by land monopolies, government-sponsored speculation, and feudal-style interventions, such as property taxes. Joseph Stromberg conducts a tour of the great land question.

Our columnists again serve up an intellectual feast. Lawrence Reed writes about perseverance in the face of adversity. Thomas Szasz further documents psychiatric slavery. Burton Folsom takes a critical look at an economic interpretation of the Constitution. John Stossel examines the “fatal conceit” of interventionists. Walter Williams defends school choice. And Robert Murphy, encountering a free-market advocate’s case for government monitoring of derivatives, responds, “It Just Ain’t So!”

Our reviewers render verdicts on books about World War II, libertarianism, early globalization, and the Constitution.

Answers: London,Tokyo, New York, Hong Kong, and the Cayman Islands. New York is the financial capital of one of the largest and wealthiest nations in the world; London, the former capital of a globe-spanning empire and still the capital of one of the most important trading nations; Hong Kong, the center of commerce for one of the largest markets in the world; and Tokyo, the capital of one of the world’s wealthiest nations. The Cayman Islands? They are 100 square miles of an “overseas territory” (the modern, politically correct term for a colony) of Britain, 480 miles from Miami and 150 miles from Cuba. Yet those 100 square miles are now the location of billions of dollars of transactions and bank deposits.

Even more strikingly, 40 years ago Hong Kong, London, New York, and Tokyo were major financial
centers and the Cayman Islands’ major industries were exporting their men to work as sailors on merchant ships and making palm thatch ropes for sale to Jamaican fishermen. The three islands (Grand Cayman, Little Cayman, and Cayman Brac) were infested with mosquitoes and flies so fierce that inhabitants ran from their homes to their cars to escape the insects, and cows suffocated on the clouds of insects they inhaled. Today the islands are a tropical paradise, virtually free of biting insects, with more than a million tourists visiting annually and the islands importing labor (almost half the islands’ population are foreigners). What happened?

A key reason for Cayman’s success as an offshore financial center is that the islands proved a hospitable jurisdiction for policy “entrepreneurship.” Several officials in the early 1950s recognized that Cayman had no choice but to develop a financial industry if Caymanians were to become wealthier. Cayman has no natural resources other than turtles and beaches. So little of its area is arable that most statistical reports list the percentage as zero. This ruled out the traditional development projects in agriculture. The small population and lack of a local market meant that industrial development schemes were obviously hopeless. Making Cayman rich required finding a way to convince other people to bring money to the islands and buy services.

These enterprising officials set out to create a legal and business climate that could compete with jurisdictions such as the United States for investors. They studied other jurisdictions’ laws and selected the provisions they thought most likely to appeal to investors. They examined the islands’ infrastructure and built what was needed to service a financial industry. For example, in the early 1960s communications from Cayman to other countries were handled by a single wireless station, operated by a man with a drinking problem. As one Cayman lawyer from that era told me, messages were fine if sent before lunch; after noon the content would be hopelessly garbled. To solve the problem, the government built an international telephone system to ensure that businesses would have reliable communications.

This entrepreneurial attitude continues. Today Cayman is the home of more hedge funds than any other offshore jurisdiction and second only to Bermuda in “captive” insurance operations (insurance companies owned by their insureds). More than 500 banks, including most of the leading banks in the world, have operations in Cayman. These successes resulted from Cayman’s adoption of statutes that provided the legal environment necessary to lure such businesses to Cayman.

If you’ve heard of the Cayman Islands, chances are you’ve heard that they do not have an income tax. Not only is there no income tax, there is no direct taxation of any kind: no sales tax, no real-estate taxes, no value-added tax, nothing. What Cayman has is a series of fees for “service” (for example, for a banking license) and a 20 percent-plus duty on almost everything imported into the island. (The major exceptions to the high tariff schedules are luxury goods; luxury goods help the tourist industry and lower tariffs on them boost economic activity by allowing Cayman to offer attractive prices on goods from Rolexes to perfume.) Because virtually everything is imported, except for some fish and turtle meat, this is effectively a consumption tax rather than a trade-distorting selective tariff.

The absence of direct taxation is important for two reasons. First, it encourages foreigners to invest capital in Cayman. Income earned by a Cayman trust or business remains tax-free until it is paid to someone in a country (such as the United States) that taxes income earned worldwide. Investors thus need not worry about losing their assets to Cayman. To ensure that investors have confidence that it will not renege on this bargain and impose a tax later, business entities, when created, are routinely granted 20-year renewable tax exemptions from the nonexistent taxes. As a result, if the Cayman government attempted to impose a tax in the future, investors would have plenty of time to move their capital elsewhere.

Even more important, the absence of direct taxation means that the Cayman government simply does not collect the sort of information routinely gathered by most countries’ governments. Want to know how much a Cayman business earns? You can’t find out by asking the government, since it never asks the business. If other governments want information, the Cayman government can’t tell them since it doesn’t collect the information in the first place.

The Cayman government’s unwillingness to pry into Cayman companies’ (and individuals’) private affairs is paralleled by the strong protection provided by Cayman’s Confidential Relationships (Preservation) Law 1995. Building on a foundation provided by the English common law, Cayman criminalized the breach of privacy by anyone with access to confidential information. Moreover, Cayman protects confidential information by requiring those seeking it to provide assurances that they can pay the costs of collecting the information and any harm that results from the disclosure.

Rule of Law

A critical part of Cayman’s success, and one reason it is more successful than some other offshore financial centers, is that investors have confidence in the legal system. Putting money in a foreign jurisdiction is risky—if a new government takes power, it can easily renege on prior government commitments. Since governments generally have a poor record in keeping their promises, this political risk is a serious problem for small jurisdictions seeking to lure investors.

Caymanians understand this and have taken several steps to guarantee to investors that the legal system is stable.

First, the final court of appeal is not a Caymanian court but the British Privy Council. By effectively “outsourcing” this critical judicial function to an entity trusted by outsiders and incapable of being pressured by Cayman politics, Cayman has shown investors that it can be trusted not to violate its legal obligations.

Second, Cayman brings in outsiders to handle sensitive cases, importing jurists from other Commonwealth jurisdictions for specific trials and even to serve on the islands’ appellate court. This helps assure investors that local prejudices will not sway the court, much as “diversity” jurisdiction in the U.S. legal system moves cases between residents of different states (over a financial threshold) to federal court to avoid the appearance of a “home court” advantage for the in-state litigant.

Third, the Cayman constitution (embodied in a British Parliament passed statute) limits the scope for local political pressure to result in changes adverse to outside capital. There is no chief minister in the Cayman government; cabinet meetings are chaired by the British-appointed governor (who is never a Caymanian); and three “official” members of the legislature are appointed by Britain rather than elected.

Fourth, Cayman has repeatedly rejected independence, preserving these crucial links to Britain. When the United Nations Special Committee on Decolonization visited Cayman in 1977, for example, Caymanians firmly rejected its efforts to push them toward independence. As Sir Vassel Johnson, former financial secretary, put it in his memoirs: “They were told by the people of the three islands in a loud clear voice, ‘Leave us alone.’”

Fifth, the key Cayman regulatory body for the financial sector, the Cayman Islands Monetary Authority (CIMA), is an independent agency rather than a politically controlled one. CIMA oversees banks and other offshore financial entities. The potential for rent-seeking in such an agency is huge—the chance to get even just a small slice of foreign investors’ money has tempted many a nation’s political class to take regulatory steps inconsistent with economic liberty. To prevent such behavior, Cayman gave CIMA extensive autonomy from local politics. For example, four of the nine directors on its board are non-Caymanians (currently two Americans, a Canadian, and a Englishman). Independent agencies and central banks per se raise their own problems, of course, but the point here is that Caymanians recognized that the need to provide security to investors required depoliticizing the regulatory framework and so raising the cost of political expropriation of outsiders’ assets.

Finally, Cayman’s budget depends heavily on financial industry fees. Given the mobility of capital, this vulnerability helps ensure that Cayman will not renege on its commitments. Indeed, Cayman’s success was partially made possible by the Bahamas’ post-independence attempt to benefit Bahamians at the expense of its offshore financial sector. In the 1960s the Bahamas was the leading offshore jurisdiction in the Caribbean. But when the newly independent Bahamian government refused in the 1970s to renew work permits for non-Bahamians in the financial industry, in order to shift lucrative jobs to Bahamians, capital fled to the Cayman Islands.

By guaranteeing its end of the bargain with foreign investors, Cayman has purchased prosperity at the price of some of its sovereignty. The price paid is remarkably low, however. Anytime Cayman wants full sovereignty, there is every indication that Britain would willingly cede it. The one thing Cayman can’t do is get its sovereignty back fast enough to seize all the money and value in Cayman companies, banks, insurance companies, trusts, mutual funds, and hedge funds. By the time the British government had the paperwork done, investors would have had their accounts in a new jurisdiction if they wish. That gives investors the comfort to invest in Cayman.

Indeed, for many Caymanians, the highest cost of remaining associated with Britain comes from its imposing its own social-policy preferences on Cayman. For example, Britain unilaterally legalized homosexual sex in 2001 and abolished the death penalty in 1991. Both actions were unpopular in Cayman, a socially conservative and deeply religious society. Even more unpopular was Britain’s action through an “Order in Council” that overrode local legislation.

Pressures to Change

Offshore jurisdictions face a variety of pressures to change their laws to eliminate their competitive advantages. Not surprisingly, for example, the countries that “lose” tax revenue to Cayman and other offshore jurisdictions aren’t happy about it. The Organization for Economic Cooperation and Development (OECD; the cartel of wealthy developed countries) dislikes the whole idea of tax competition, the “harmful” lowering of tax rates to lure business. Fortunately, the Bush administration has shown less interest in helping the other high-tax OECD countries in their quest to reduce tax competition than the Clinton administration did, but the problem lurks in the background.

The offshore financial industry also faces threats from crime. The term “offshore” often calls to mind unsavory deals of the type John Grisham wrote about in The Firm. And some offshore jurisdictions have fallen victim to corruption and crime. For example, historian Jan Rogozinski called Aruba “the world’s first independent mafia state,” and most of Montserrat’s banking industry was closed down after a financial scandal involving money laundering.

Resisting illegal activity is essential for successful offshore jurisdictions for at least two reasons. Most important, illegal transactions often bring with them corruption that is destructive of the level of trust necessary for a civil society to function. More pragmatically, illegal activity threatens the toleration of offshore jurisdictions by “onshore” jurisdictions such as the United States and the European Union. The physical and legal independence of jurisdictions such as Cayman, Bermuda, or the Channel Islands is precarious. It would take little effort for Britain to simply override Caymanian laws by altering the constitution or, in a more extreme case, for a company of U.S. Marines to overrun the island.

Less extreme onshore legal changes could cripple important aspects of the offshore financial industry. Of course, offshore jurisdictions are useful to European and American investors, which provides a degree of political protection against such threats. If, however, offshore centers become identified with al Qaeda financing, they are extremely vulnerable to onshore nations’ pressure. Keeping their businesses in the legitimate financial sectors helps offshore financial centers protect their independence.

Cayman has struck a balance between cooperating enough with onshore jurisdictions to preserve their toleration of offshore activity and maintaining its competitive advantage. Three steps help Cayman succeed in doing so. First, it insists on the principle of dual criminality in all cooperative efforts. That is, it will help other jurisdictions obtain information about funds in Cayman only if the activities being investigated are illegal there also. The result: cooperation on terror financing but not on tax investigations.

Second, Cayman assists foreign governments only in response to requests for specific information; it will not participate in “fishing expeditions” into a suspect’s funds or activities.

Third, Cayman has expanded the areas in which it offers a competitive advantage well beyond tax levels. Caymanian accounting rules and insurance laws, for example, are far more favorable to the operation of captive insurance companies (through which firms can self-insure against some risks) than either U.S. accounting rules or most U.S. states’ laws.

Not Quite Perfect

But wait—isn’t this the Cayman government that is doing these things? Doesn’t that compromise the integrity of the system? We should be skeptical of the classical-liberal pedigree of offshore jurisdictions for precisely this reason. Cayman may be freer than most places with respect to financial matters, but it is still not a libertarian haven, and so there had to be a flaw.

And it definitely is not a libertarian haven. A socially conservative society, Cayman has plenty of laws that many libertarians would object to: drug prohibitions, bar closing rules (midnight on Saturdays) built around religious observance, and the like. Cayman has also made many of its investments in infrastructure through government entities. The government built the airport, runs a national airline that frequently loses money, created the law school, set up the telecommunications network, and has undertaken a host of other activities that most libertarians and classical liberals would reject as outside the acceptable range of government activities.

Despite all these flaws, Cayman plays an important role in limiting government elsewhere. What Cayman provides is competition that keeps larger states more honest. All aspects of Cayman’s legal system need not meet the ideal for it to play this role. Cayman’s tax and regulatory rules force governments elsewhere to restrain their resource grabs. By providing an alternative, Cayman forces a sorely needed measure of discipline on the United States, European Union, Japan, and other “developed” countries not just with respect to taxes but also to a host of regulatory measures.

Moreover, because Caymanian society is small, the government is a lot less like the grasping Leviathan of larger states. Indeed, the society seems to have reached a consensus on the value of the offshore financial industry that is making the population among the wealthiest in the Caribbean, and that consensus is reflected in the tenor of the politics. Parties have not yet taken root in Cayman, and competition for office seems more based on personalities and competency than partisan divisions. The Cayman government has certainly made missteps from a libertarian perspective. Nonetheless, they have been less destructive of liberty, particularly economic liberty, than those of many of its larger neighbors.

Cayman’s success is due to thinking differently about government. Cayman has gotten rich by realizing that the fundamental problem of government is to find institutions that convince people that the government won’t take their money. In part, it is because it is small that Cayman is able to make credible commitments in the ways I have described. But it is also due to the creative design of its institutions that Cayman has succeeded. For example, in 1776 separating from Britain was a means of limiting government rent-seeking; today remaining connected to Britain offers Cayman an equivalent set of limits.

Can Cayman serve as a model for other governments? Many of the specific solutions chosen by Caymanians are unlikely to function if scaled up to a country the size of the United States. It could, however, prove an important model for local governments seeking to reassure investors that they will not find a new set of rules in place the day after their investment becomes final.

The entrepreneurial attitude that made Cayman the fifth largest financial center less than 40 years after the biggest local industry was thatch-rope manufacturing could be translated even to larger-scale governments. If people can learn to stop viewing governments as the source of subsidies and recognize the connection between institutions that protect property rights and wealth, other entrepreneurs may discover institutions that effectively limit even the most rapacious Leviathan.

Read More

Literature on Cayman history is hard to come by, and most Caribbean histories give Cayman little attention. The story of it offshore industry is told in Sir Vassel Johnson’s somewhat uneven autobiography, As I See It (Book Guild Ltd., 2001). Michael Craton’s Founded Upon the Seas (Ian Randle, 2004) is an excellent general history of the islands and includes some material on the financial industry. If you visit Grand Cayman, the government archive (near the airport) has a fascinating collection of oral histories; unfortunately none are available on the web. The Cayman Islands also feature in a sadder story involving classical-liberal principles, the destruction of a highly successful private conservation effort to save the endangered Atlantic green sea turtle by U.S. environmental legislation. This is described in Peggy Fosdick, Last Chance Lost (I.S. Naylor, 1994).