The Economic Foundation of the Walker Model: The Gravity Model by Prof. Dr. Brigitte Unger

1. The Economic Foundation of the Walker Model: The Gravity Modelby Prof. Dr. Brigitte Unger Presentation prepared for the Conference on Tackling Money Laundering, organized by the Utrecht University School of Economics, 2nd and 3rd November 2007 Tackling ML 3.11.2007

2. Overview • Why I chose for the Walker Model • A Revised Walker Model Measured for the Netherlands • The Theoretical Underpinning of the Model: The Gravity Model • Lessons from modern trade theory • Future Challenges Tackling ML 3.11.2007

3. 1. The Walker Model • A pioneer study from 1994 • Allows for a framework to measure money laundering per country and worldwide • Is a positive example for interdisciplinary work between criminology and economics • Recently updated (Walker 2005) • Is based on a solid model of economic theory Tackling ML 3.11.2007

4. The Walker Model • consists of two parts of which the second partis thecontroversial one in the debate on money laundering • The proceeds from domestic crime that are being laundered • The proceeds from foreign crime that flow into a country for laundering Tackling ML 3.11.2007

5. 2. A Revised Walker Model Percentage of World Criminal Money Flowing into a country X (the Netherlands) Country X, countries yi i=1...n Attractiveness=f(GDP per capita, BankSecrecy, AntimoneylaunderingPolicy, SWIFTmember, Financial Deposits,-Conflict,-Corruption,-Egmont Group. Distance deterrence=f(Language,colonial background,trade,physical distance) Tackling ML 3.11.2007

6. 2. ATTRACTIVENESS top 31 out of 220 countries Unger et al 2006 Unger et al 2006 Walker 1995 16. Iceland Canada Portugal Denmark Sweden Monaco Japan Finland Germany New Zealand Belgium Italy France Cyprus Czech Republic Latvia 16. Australia Isle of Man Vatican France San Marino Germany 22.Netherlands Italy Finland Greece Japan Malta Sweden 29.US Denmark 31.UK • 1.Luxembourg • Bermuda • Switzerland • Caymen Islands • Norway • Hong Kong • Austria • Liechtenstein • Belgium • Aruba • Jersey • Iceland • Canada • Ireland • Singapore • Walker 1995 • 1.Luxembourg • 2.US • Switzerland • Caymen Islands • Austria • 6.Netherlands • Liechtenstein • Vatican • 9.UK • Singapore • Hong Kong • Ireland • Bermuda • Bahamas • Norway Tackling ML 3.11.2007

7. Other Countries’ Criminal Money Flowing into the Netherlands 2.Flows of Dirty Money Into the Netherlands Laundering depends on Attractiveness and on ‘Distance’ Language,colonial background, trade, physical distance 14,5 bill Euro from Dutch crime US US, Russia,Italy Germany, UK, France.. UK Dutch Antilles, , + 4 bill Russia Netherlands Colombia Netherlands Germany Turkey Spain +Through flow =18,5 bill Money Laundering in the Netherlands about 5% of Dutch GDP Tackling ML 3.11.2007

8. 3. The Theoretical Underpinning of the Walker Model:3.1. Newton’s Apple • Fij = G* Mi*Mj/ (Dij)2 • Fij...Attractive Force between object i and j • Mi....Mass of object i • Mj ..Mass of object j • Dij...Distance between object i and object j • G...Gravitational constant • In 1687, Newton proposed the “Law of Universal Gravity”, which held that the attractive force between two objects i and j depends on their masses, the square distance between these objects and a gravitational constant. Tackling ML 3.11.2007

9. 3. The Theoretical Underpinning of the Walker Model:3.2. Tinbergen’s Old Gravity Model of 1962 • Fij = G* Mi α * Mj β / Dij θ • The export flows from country i to country j depend on the GDP of both the exporting and importing country and the distance between them. • Note that if α, β = 1and θ =2, then this is the same as the original Newton formula: • Fij = G* Mi*Mj/ (Dij)2 Tackling ML 3.11.2007

10. 3. The Theoretical Underpinning of the Walker Model:3.3. The Gravity Model in Modern Trade Theory • The trade flows from country i to country j Fij = sij*Mj • Where sij is the share of country j’s income Mj spent for goods from country i. • sij = g(mi, ni, Dij) / Σ g (ml, nl, Dlj) mi……quality of goods of country I • ni….variety of goods of country i • Dij…distance between country I and j • This share increases if country i produces a greater variety of goods (ni) or a higher quality of goods (mi). This share also decreases with distance. • Depending on the trade theory used, either mi=1 (which means all products from a country have the same average quality) or ni=1 (each country exports only one single good). • Under the assumption that mi=1 and that all firms q are of the same firm size, the number of products ni = Mi/q. The higher the income of the country, the more products will be produced, and the larger the firms size in the country, the less variety will be produced (monopolistic trade models, Dixit Stiglitz). Tackling ML 3.11.2007

11. 3. The Theoretical Underpinning of the Walker Model:3.3. The Gravity Model in Modern Trade Theory contd • If mi=1 and all firms q are of the same firm size, the number of products ni = Mi/q. • The higher the income of the country, the more variety of products, the larger the firms size in the country, the less variety (monopolistic trade models). • After some modification, follows • sij = Mi Dij – θ Rj where Rj = 1/ Σ l (Ml, Dlj – θ) and • from this follows Newton’s-Tinbergen’s formula • Fij = Rj * Mi*Mj / Dij θ Tackling ML 3.11.2007

12. 3. The Theoretical Underpinning of the Walker Model:3.4. Walkers Model is a Modern Gravity Model • Fij = Rj* Mi α * Mj β / Dij θ • Fij/Mi = Attractiveness j /Distance ij2 where • Fij/Mi = (GNP/capita)j * (3BSj+GAj+SWIFTj-3CFj –CRj +15)/ Distance ij2 • Where GNP/capita is GNP per capita, BS is Banking Secrecy, GA is Government Attitude, SWIFT is SWIFT member, CF is Conflict, CR is Corruption. • If one compares this to the original gravity model, Walker assumes, Rj= (3BSj+GAj+SWIFTj-3CF-CRj+15) and Mj=(GNP/capita) j. He has divided the flow formula by Mi = (the proceeds of crime). Tackling ML 3.11.2007

13. 4. Lessons from Modern Trade Theory • Tinbergen’s ad hoc formula was progressively micro-founded. • Anderson (1979), showed that the gravity model was evident in expenditure share models • Helpman (1984) and Bergstrand (1985) demonstrated that the gravity model could also be derived from models of trade in differentiated products. • Deardorff (1998) showed that a suitable modelling of transport costs produces the gravity equation as an estimation, even for the Heckscher-Ohlin model. • Helliwell (2000), Head (2003) role of distance, colonial background, language Tackling ML 3.11.2007

14. 4. Lessons from Modern Trade Theory • The role of distance • It is a proxy for transport costs • it indicates the time elapsed between shipment • - damage or loss of the good (ship sinks in the storm) • spoiling of the good • loss of the market (purchaser unable to pay once it arrives) • It stands for transaction costs (searching for trading opportunities, establishment of trust between partners) • It stands for cultural distance (clashes in negotiation style, language) ‘Countries that speak the same language will trade twice to three times as much as pairs that do not share a common language” (Helliwell 2000) • Role of borders, overestimation of effective distance when one takes capital coordinates Tackling ML 3.11.2007

15. 4. Future Challenges • better micro-foundation of the Walker model • cooperation with criminologists for studying criminal behavior • Variables in the attractiveness indicator still arbitrary • weights of variables in attractiveness and distance indicator still arbitrary • It was a long way from Tinbergen’s ad hoc formula to the micro foundation by modern trade theory. Similar is needed for criminal flows Tackling ML 3.11.2007

16. THANK YOU ! Prof. Dr. Brigitte Unger Utrecht School of Economics Janskerkhof 12 3512BL Utrecht The Netherlands +31-(0)30-253-9809 B.Unger@econ.uu.nl Tackling ML 3.11.2007