European Journal of Law and Economics, 7:225–240 (1999) © 1999 Kluwer Academic Publishers Money Laundering: the Economics of Regulation DONATO MASCIANDARO Professor of Monetary Economics, Paolo Baffi Centre for Monetary and Financial Economics, Bocconi University,Via Sarfatti 25, 20136 Milano, Italy, e-mail: donato.masciandoro@uni-bocconi.it Abstract The paper undertakes an economic analysis of money laundering and of anti-money laundering regulation within a theoretical and normative framework. The model is then applied to the development of the Italian anti-money laundering regulation in recent years. Keywords: Crime, money laundering, regulation JEL Classification: K4, G2 Economic research has not yet systematically undertaken the analysis of the existing interactions between criminal economy and financial markets. The present work belongs to a research field increasingly interested in such issues and focuses on the economic analysis of money laundering (Masciandaro, 1993, 1994, 1998; Hallet, 1994) following the structure explained below. Section 1 contains the economic analysis of money laundering in the context of crimi- nal activities. We will first provide a theoretical definition of the phenomenon in order to highlight the substantial economic function of money laundering, which is to transform potential purchasing power into an effective one. We will then present a theoretical analysis of the mechanisms ruling the growth of this illegal activity as well as of its ties with the development of a criminal economy. The model we propose, based on a previous approach introduced by Masciandaro (1993, 1994), will allow us in section 2 to further analyze money laundering and anti- money laundering policies adopting a positive theoretical perspective. First we identify the role of money laundering as a multiplier of criminal financial activities. Such a “polluting” element of the economy becomes more considerable: i) the lower the aggregate transaction costs of undertaking money laundering; ii) the larger the share of reivestment in illegal activites; iii) the more pressuring the need of financing such reinvestment with “clean” liquidity; iv) the wider the differentials in expected real returns between illegal and legal activities; v) the larger the initial volume of illegal revenues that has to be “cleaned”. Kluwer Journal @ats-ss11/data11/kluwer/journals/ejle/v7n3art3 COMPOSED: 02/26/99 10:38 am. PG.POS. 1 SESSION: 11