Quora Answer: How Does Money Laundering Lead to a Rise in Inflation?

The following is my answer to a Quora question: “How does money laundering lead to a rise in inflation?”

Money laundering is the concealment of the origins of illicit funds through placement and integration into the economy.  Inflation is the general increase in prices and the decline in the purchasing power of money.  Since the black economy still contributes to a nation’s GDP, the influx of funds creates liquidity.  That liquidity feeds consumer purchases as money that was never meant to circulate legally now moves through the system.

The funds themselves originally come from legitimate sources.  They pass into the black economy, and then get reintegrated back into the legal one.  Money is not created from nothing in this process.  Counterfeiting would be a different matter entirely, since that adds new currency units to the supply.  Laundering does not.  It relocates money already in existence.  As such, laundering does not meaningfully drive inflation on its own, because the sums involved are a small share of overall GDP.  The United Nations Office on Drugs and Crime estimates laundered funds at 2 to 5 per cent of global GDP annually, not one large enough to move a national price level on its own.

If laundered proceeds constitute a significant share of the economy, the problem ceases to be inflation and becomes something worse.  Colombia proves this.  Cocaine trafficking generated roughly 7 per cent of Colombian GDP and 70 per cent of exports in the early 1980s.  Dollar proceeds flooding into the country through informal channels appreciated the peso, a textbook case of Dutch Disease, the same mechanism that hollowed out Dutch manufacturing after the discovery of North Sea gas.  Colombia’s own industrial and agricultural export sectors lost competitiveness as the currency strengthened on the back of narco-dollars rather than genuine productivity gains.  Research on the period found the phenomenon fuelled inflation, corruption, and parallel economic structures simultaneously, not sequentially.  A country does not reach 7 per cent of GDP from illicit proceeds without also reaching civil conflict, institutional capture, and a currency mispriced against its own real economy.

At the scale most countries experience it, money laundering is a rounding error against inflation.  Colombia’s own history is the exception that proves the rule.  Once illicit proceeds cross from marginal to structural, the country is no longer managing an inflation problem.  It is managing a state capacity problem, and Colombia spent decades finding out exactly how expensive that distinction becomes.

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Terence Nunis | Executive Chairman, Equinox Zenith | Author, The 1% Playbook: The Billionaire Cheat Code