With an estimated $9 billion in sales last year, marijuana is a booming business in the United States. Thirty states allow for medical use of cannabis, and nine states and the District of Columbia permit pot for recreational use. Like any burgeoning industry, there are innovators looking to forge ahead with ideas to increase efficiency and profits. But that growth is hampered by the paradox between state and federal policies toward the drug. Peter Conti-Brown, Wharton professor of legal studies and business ethics, has written a compelling issue brief for the Penn Wharton Public Policy Initiative that explains how federal banking regulations force this cash-based enterprise to operate in a “gray market.” He joined the Knowledge at Wharton show, which airs on SiriusXM channel 111, for a revealing discussion about the complex political and economic barriers faced by marijuana-related business owners who want to scale their operations.
An edited transcript of the conversation follows.
Knowledge at Wharton: Give us some background on this issue. What has been missed about legalizing marijuana?
Conti-Brown: It depends on how one views the future of marijuana-related businesses. If we’re seeing them as a mom-and-pop shop, corner bodega, one-off used car lot sort of system, then there are a lot of reasons not to be worried about the failure of marijuana-related businesses to integrate into the financial system. Why? Because if you’re a business owner with a single, small business, you don’t have many growth ambitions. There’s a lot of good reasons for you to prefer a cash business. Some of them might be completely consistent with your economic model. You don’t want to pay for credit cards and credit card exchanges. Others are a bit more nefarious about tax invasion and that kind of thing, reasons why you would want to be under the table.
But there’s also a difference here for marijuana-related businesses that wouldn’t pertain to a bodega or a one-off sole proprietorship … even those institutions are doing banking. They have checking accounts, payroll and those kinds of systems in place. Marijuana-related businesses face a huge obstacle in that banking them, even if you are going to do a mostly cash business, is risky because we in the United States are a house divided. From the state’s perspective, in these states where marijuana has been legalized, marijuana is essentially the same as chewing gum or candy bars. There are some more regulations put in place, but it’s just a regulated food or a consumer good or product.
From the federal government’s perspective, this is the same as imported ivory or heroin or any other illegal substance or good. So long as that difference exists, our banking system, which is dominated by federal regulations, cannot allow banks to participate in this even when the states have legalized it.
Knowledge at Wharton: Part of what you discuss in this brief involves the city of Sacramento, Calif., failing to report some of the tax receipts from these businesses.
Conti-Brown: That’s the tax evasion problem. That’s why I say this might look like something that the small-business owners might cheer. Their tax liability is significantly lower than what it would be if they weren’t on an all-cash system. From a social perspective, under-enforcement of our tax laws or tax evasion is not a desirable thing. Once we’ve agreed about the appropriate level of taxation, we would hope for compliance with it.
“In these states where marijuana has been legalized, marijuana is essentially the same as chewing gum or candy bars.”
The city of Sacramento is seeing exactly this problem. I keep referring to these bodegas or small businesses that rely predominantly on cash, but that’s not just the problem. In many cases, these marijuana-related businesses are eager to integrate more fully into a financial system, in part because maintaining cash in this way, without an ability to take that cash and make it a part of the financial system through banking relationships, is a huge logistical and security risk. The cities and states that hope to gain from the tax revenues for legalized marijuana-related businesses are going to suffer. More to the point, this industry simply won’t be able to take root and grow. The lack of banking integration and the instability from a federal perspective on banking policy is an obstacle that a lot of marijuana enthusiasts haven’t taken as seriously as they should.
Knowledge at Wharton: It seems that policymakers overlooked a lot of details in the legalization of marijuana.
Conti-Brown: I think what we’re seeing here is this piecemeal, incremental approach to legalization that hasn’t had a grand design or a grand master strategy. This isn’t a criticism of those in the legalization movement, because what could they have done? If your goal is to acclimate society to legal marijuana use, then using these laboratories of democracy — as states are famously called in our federalist system — I think is the right strategy. It’s just a recognition that unlike other kinds of state policies, here the reach of the federal government is so strong and so dominant that even sympathetic state banking regulators will be preempted by the federal government.
In 2013-2014, the Obama administration said, “Our prosecutorial priorities are going to be different. We’re not going to intervene here, we’re not going to interfere.” I started writing this and had a full draft before the Trump administration said it was abandoning that previous articulation of the Department of Justice’s prosecution priorities. That abandonment has occurred, so the banks that would service these marijuana-related businesses are on very shaky ground if they’re trying to guess which direction the federal government is going to go.
Knowledge at Wharton: Is there a hint of direction? U.S. Attorney General Jeff Sessions has made his opinions pretty well known about what he believes is the illegal state of marijuana use in America.
Conti-Brown: There has been no mistaking it. Of the sitting senators in 2016, Jeff Sessions probably took the hardest line on marijuana. By appointing him to be attorney general, President Trump, maybe intentionally, has reversed federal policy with respects to prosecutorial discretion on marijuana. Is that permanent? We’re seeing headlines about the fraught relationship between Trump and Sessions. Who knows how long the attorney general will stay in office? His replacement will have a lot of authority to zag where Jeff Sessions has zigged.
But that’s just the problem, right? If it’s entirely dependent on who is sitting in that big chair, how can you build a business that you are hoping will extend far beyond when Jeff Sessions or his successor are out of office? For that, we need Congress to act. I think this is not a controversial position in places like Washington and Colorado, where the governors and the state banking regulators and other authorities have said, “Please just give us the space to take our own policy direction where it will go.” They can’t do that as long as Congress has said that, with respect to federal law, dealing marijuana is the same as engaging in trade with North Korea or Iran.
Knowledge at Wharton: Colorado was the leader in legalizing marijuana. We’ve heard stories about the unbelievable financial success of that industry in Colorado. How does that state handle the legal differences at the federal level?
“What we’re seeing here is this piecemeal, incremental approach to legalization that hasn’t had a grand design or a grand master strategy.”
Conti-Brown: The state has said to small banks, you can and should do business with these marijuana-related businesses. But the banks are doing this with trepidation. These are state-chartered banks, not nationally charted banks. They are still linked to the FDIC, but they’re not linked to the Comptroller of the Currency. They are still linked to the Fed because the Fed oversees the payment system, but the advantage they have going for them is that they are grandfathered in. They already were a bank participating in the payment system. That’s all fine and good, but innovation requires there to be new entrants who can shake up the way the business is done.
Colorado is such a great example of this because there was a credit union that put all of its ducks in a row and went transparently to the state of Colorado and said, “We are going to be a credit union for marijuana-related businesses. We are going to specialize in this business. We’re going to have other depositors and other financial services and products, but that’s going to be our focus.” And the state of Colorado said, “Great, many happy returns. Go forth and prosper.”
What historically has been an extremely routine approval from the Federal Reserve now took eight months for the Fed to finally reach a decision. When they did, they said, “No, you can’t have this master account,” and that’s a death sentence to a financial institution. We are in a space right now where the state of Colorado is saying to these incumbent banks but not new entrants, “Please service the marijuana-related businesses.” But the federal government is saying, “If you do that, you’re engaged in money laundering for an illegal activity.”
Normally, it’s more harmonious than that. It’s OK for one state moving in this direction, one state moving in that direction, the federal government stepping aside. That is how federalism works, and it has been our system for many years. But banking has not been a state-based system arguably since the 1860s. I think everybody agrees that the federal government dominates banking and has done so since the early 20th century, and without question after World War II.
“Innovation requires there to be new entrants who can shake up the way the business is done.”
Knowledge at Wharton: We aren’t seeing any kind of reconciliation in policy between the states and Congress. More states are making their own rules because they don’t expect the federal government is going to come on board.
Conti-Brown: This is why I love being a political historian and not a political scientist. A political historian looks backward and tries to make sense of things that have already happened; a political scientist is trying to look forward and predict the future. I have just absolutely no idea where this is going to go at the congressional level.
I could see as early as this 2018 midterm election, more conservative Republicans in places like West Virginia or Ohio or Michigan or other places that are at the political center of the United States, saying, “Yeah we’re on the losing side of this. I’m going to embrace legalization, I’m going to do this as a Republican, and I’m going to argue that this is going to be the answer to our opioid crisis. I’m going to run on that.” We’ve already seen some people making noises in exactly that direction.
A prediction I would make here is that if even a small number of Republicans don’t embrace this, if this remains partisan, then I think the deadlock will remain for the indefinite future. But if more Republicans and those few conservative Democrats come around, then I would think that we would see speed not in federal legalization but in the abandonment of these banking policies such that if it’s legal in Colorado, it’s fully legal. That’s opposed to what we have right now, which is it is fully illegal in the state of Colorado, but the state of Colorado doesn’t think so.
Knowledge at Wharton: What does this mean for the future of the marijuana industry in the U.S.? There is increasing entrepreneurship and innovation in this sector.
Conti-Brown: In some sense, this is very good for innovators if you have no growth ambitions. It does favor the scrappy innovator as opposed to the incumbent who, if you want to grow and become a real national presence, you’re not able to do so. A lot of people have been very afraid that the legalization of marijuana is just going to lead to big marijuana, like big tobacco companies that will come and just take over the system. That’s not going to happen so long as it is illegal to bank these institutions, and these institutions are all cash — not by a long shot. The bad news is innovation has rarely succeeded in economic history [because of] these scrappy, small businesses with no growth ambition. Growth ambition is at the heart of innovation, and the ambitions of the innovators in marijuana-related businesses are already larger than that. Given that fundamental reality, this is an obstacle, and they’re not getting over it. Indeed, we’ve seen a big step backward for them in Jeff Sessions.
Knowledge at Wharton: Is this a strictly partisan issue?
“Congress is a reactive institution. The presidency is a proactive institution immediately following a presidential election, then becomes a reactive institution.”
Conti-Brown: Not at all, and I think it’s slipping as a partisan issue. Here is my analysis of the political climate and why this might be a good time in 2018: All Republicans have acknowledged that the wind is at the back of the Democrats. This is a historical reality. There have only been a few exceptions where midterm elections go in favor of the incumbent. Even for that baseline in historical reality, things are not great for Republicans given President Trump’s negatives are pretty high. So, the Republicans cannot run on incumbency alone. They can attack Democrats, but that is hard to do. It’s hard to attack the minority levers of governmental power in the hands of the Republicans, so that’s not going to work. They’ve got to find other issues. The approval ratings of marijuana legalization have been creeping upward, so this might be an attractive wedge issue for some moderate Republicans to run on this platform.
My prediction is that, between now and the November 2018 midterm elections, we are going to see more Republicans — especially in places that are hard hit economically and with the opioid crisis — say they are in favor of marijuana legalization.
I should be clear, I’m neutral on the question of whether marijuana should be legalized in a given state’s jurisdiction. I am skeptical that it should be fully legalized at the federal level. But as you see in my brief, I am a big advocate for the federal government to rationalize this system, to allow Colorado to go in its direction, to allow Utah its neighbor to go in a very different direction. That is where federalism is at its best, and it simply can’t happen with where we are today.
I think the places where we are going to see most movement are going to be those states that have in the last decade fielded both Republican and Democratic representatives. West Virginia and Ohio are good examples. They are hard hit economically and hard hit by the opioid crisis. I think those are the places we should be watching.
Knowledge at Wharton: There are so many other pressing issues before Congress right now, such as gun control and immigration. Do you think marijuana will get traction?
Conti-Brown: I think that is fair. Congress is a reactive institution. The presidency is a proactive institution immediately following a presidential election, then becomes a reactive institution. In order for this to happen, we would have to see something like a public policy crisis around marijuana-related businesses. Those crises will come. This house divided can’t stand. There are going to be real issues with marijuana-related businesses being held up at gunpoint because they’ve got a bad cash management system. Maybe people will be hurt or, God forbid, killed.
“From the federal government’s perspective, this is the same thing as trafficking in panda bears. It’s illegal.”
I think we can anticipate this. These are the risks of having a partially legalized business. These are the risks of the gray market, which is what marijuana is in Colorado. You can bet once this punches through to a national conversation that our legislative policy decisions have created a crisis, then I think we can expect Congress to react — because that’s what Congress does.
Knowledge at Wharton: How can this be fixed, at least in the short term, to allow marijuana-related business operators to use digital banking and not rely so much on cash?
Conti-Brown: Any challenge I would offer to any entrepreneur in this space is, what do you do with cash? What do you do to bank? Every single business is going to have to confront this. Either you go Walter White [from the AMC television series] “Breaking Bad” style and launder it through a car wash and just stack it up in big billed chunks in some storage unit — that’s the drug dealer model — or you make it legit. The state of Colorado is hungry for this.
In the state of Massachusetts, the banking regulator there just said, “Hey, we should have a state bank that does this.” But the problem is the state bank, private bank, they will all face the same problem: From the federal government’s perspective, this is the same thing as trafficking in panda bears. It’s illegal. And so long as it’s illegal, banks are going to be skittish about this.
