Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

September 2008 Selected Offshore News Clips

(Especially noteworthy articles’ dates highlighted in gold.)

September 1, 2008

Income derived from sources "within the U.S." is subject to reporting and taxation under the Internal Revenue Code. When a foreign entity is constructively engaged in an "effective trade or business in the U.S.," it is taxed by the U.S. on the portion of its income that is "effectively connected" to the U.S.

What constitutes "effective" in practice? As one might guess, there are ambiguities at times. But there is a large body of court cases and revenue rulings that are available concerning this precise matter. This piece from Robert Sommers, a San Francisco-based tax attorney with over 30 years experience and author of the Web-based "Tax and Trust Scam Bulletin Board", is a good starting point for those new to the subject.

The general case considered is where a foreign entity is selling products to a U.S.-based customer. Generally, a sale to a U.S. purchaser does not in and of itself mean that the seller is engaged in an effective trade or business in the U.S. But start adding typical intermediaries such as a U.S.-based sales agent or warehousing subsidiary and suddenly "effective" does become the operative concept. Sommers considers various illuminating example cases.

Note that a business falling under the jurisdication of the U.S. tax code does not necessarily imply that substantial taxes are thereby owed. The business is entitled to the same deductions as those of a purely U.S.-based business.


Many foreign corporations which are based in countries that do not have an income tax treaty with the United States, sell products to purchasers located in the U.S. Often, the contracts for the products are negotiated overseas and shipment of the goods is made directly from the foreign corporation to the U.S. customer.

This explanation will discuss, in general terms, how U.S. tax law applies to those sales. In particular, this document will discuss under what circumstances the foreign corporation will be liable for the payment of U.S. income taxes on those sales.

This explanation will consider the following hypothetical situations:

Example I: Parent Corporation (hereafter "Parent"), a foreign corporation based in Taiwan negotiates the sale of computer display screens (hereafter "screens") to Compac, a U.S. corporation based in Texas. All negotiations take place in Taiwan and the contract is signed in Taiwan. Shipment will be made to ACME TRADING (U.S.A), Corp. ("ACME") who will then clear the shipment through customs and place the screens in its bonded warehouse.

Example II: This example is the same as Example I, except that the foreign corporation has a wholly-owned subsidiary (hereafter "Sub") with a fixed place of business in California and has employees located at its business site. Sub’s employees will engage in after-sales service of the screens, will call on Compac to determine its satisfaction with the screens and to make further sales of the screens.

Situation A: In this situation, ACME merely ships the entire order of screens to Compac once the screens have cleared customs.

Situation B: In this situation, Parent will use ACME as its agent to warehouse the screens and will provide Compac with "just-in-time" (hereafter "JIT") inventory of the screens. Under JIT, Compac will either notify Parent or ACME when it needs a shipment of screens and ACME will then ship the screens. Legal title to the screen will remain with Parent until the screens are shipped to Compac.


Whether Parent will be considered as having engaged in a trade or business in the U.S., and, therefore, be liable for U.S. income taxes on that portion of its income that is effectively connected with its U.S. trade or business, under:

a. Example I, Situation A: When Parent merely ships goods directly to its customer in the U.S.;

b. Example I, Situation B: When Parent ships goods to ACME who will inventory the goods in its bonded warehouse under the concept of JIT inventory; or

c. Example II: When Parent has a U.S. subsidiary with a fixed place of business in which the subsidiary provides sales and services in connection with the sale of the screens.


1. Under Example I, Situation A, Parent will not be engaged in a trade or business in the U.S. and will not file a U.S. tax return.

2. Under Example I, Situation B, the activities of ACME with respect to the JIT inventory of Parent’s screens, where the sale of those screens occurs once Compac decides to purchase the screens, will cause Parent to be engaged in a trade or business in the U.S. and Parent and will have to file a U.S. tax return.

3. Under Example II, Parent will be engaged in a trade or business in the U.S. and will have to file a U.S. tax return. This would be true even if the subsidiary was engaged in a totally separate line of business, such as the sale of vintage wines in the U.S.
Note: Even if Parent is engaged in a trade or business in the U.S. and, therefore, will have to file a U.S. income tax return, the actual taxes may be minimal.

A. General Explanation of the Law

Income from sources within the U.S. is subject to taxation under Internal Revenue Code Section 861. Under IRC § 864(b) and (c), when a foreign corporation is engaged in [an effective] trade or business in the U.S. (hereafter "ETB"), it is taxed on the portion of its income that is effectively connected with its trade or business (hereafter "ECI" [effectively connected income]). The tax is computed, in general, in the same manner as a U.S. corporation or individual doing business in the United States. Taxes are computed on a net income basis (gross income less deductions). Corporations generally pay tax on their net incomes as follows:
Taxable Income Rate
No income to $50,00015%
Over 50,000 to $75,00025%
Over 75,000 to $10,000,000    34%
Over $10,000,00035%
Therefore, a foreign corporation with taxable income of $10,000 will pay a $1,500 tax on its income. Distributions of dividends from the Sub to Parent will be taxed at a flat rate of 30% under IRC Sec. 881(a) when the dividend is paid.

In general, a foreign corporation uses the same rules as a domestic corporation to calculate its net book income which is subject to taxation; however, the foreign corporation is subject to tax only on its effectively connected net book income. In other words, income and deductions are determined with respect to the foreign corporation’s U.S. business operation, as determined on its applicable financial statement. See IRC Reg. 1.56-1(b)(6)(ii)(B).

In addition, if the foreign corporation operates a branch in the U.S., rather than a corporation, there could be a branch profits tax of 30% under IRC Sec. 884 (as though a dividend were paid to Parent under IRC Sec. 881(a)), in addition to the regular tax on ECI under IRC Sec. 11. The purpose of the branch profits tax is to equalize the tax treatment between a foreign corporation that uses a corporate subsidiary or an unincorporated branch in the U.S. Therefore, using a branch office in the U.S. will subject the foreign corporation to an immediate double taxation on its effectively connected income.

B. U.S. Trade or Business

A foreign corporation engages in a trade or business in the U.S. when it is involved in a profit-oriented activity within the U.S., either directly or indirectly, or through agents, when the activity is regular, substantial and continuous. CM v. Spermacet Whaling and Shipping Co., 281 F2d. 646 (6th Cir. 1960). The court in Spermacet found that a company that hunted whales on the high seas for sale to a U.S. oil refiner was not engaged in a U.S. trade or business despite close financial links to the U.S.

Sales by a foreign corporation to U.S. customers directly, without the use of an office, agent or employees in the U.S. is generally not a trade or business. U.S. v. Balanovski, 131 F Supp. 898 (S.D.N.Y. 1955). Green Export Co. v. U.S. 285 U.S. 383 (Ct. Cl. 1961); Perry Group, Inc. v. U.S., 1980-2 USTC ¶ 9603 (D.C. N.J. 1980). Use of a sales person in the U.S., however, will cause the foreign corporation to become an effective trade or business. Revenue Ruling 56-165, 1956-1 CB 84

In Example I, Situation A, Parent has no office or employees in the U.S. and is not conducting business through an agent located in the U.S. Consequently, FC is not engaged in a U.S. trade or business.

In Example I, if the FC sells screens and then sends its employees to the U.S. to advise Compac in connection with the screens, the FC will not be ETB, according to Private Letter Ruling 7739023. If, however, the FC sends its employees for the purposes of selling additional screens and if the employees have the power to enter into binding contracts with Compac, then the FC will be ETB according to Revenue Ruling 56-165, 1956-1 CB 849 and Revenue Ruling 55-282, 1955-1 CB 634.

C. Effectively Connected Income from U.S. Sources

ECI is taxed by IRC § 882(a) at graduated rates and a foreign corporation deducts all expenses incurred in earning ECI, just like a domestic corporation. U.S. source income that is not ECI is generally considered "fixed or determinable, annual or periodic" income (hereafter "FDAP") and is taxed at a flat rate of 30%. FDAP income includes, interest, dividends, rents and royalties.

Income that is not FDAP is considered ECI if it comes from sources within the U.S., such as inventory and other property held for sale to customers in the ordinary course. This rule applies, whether or not the income is actually connected with the foreign corporation’s U.S. trade or business. IRC Sec. 864(c)(3). To illustrate this point, Rhoades and Langer in their treatise, Taxation of Foreign Investors, ¶ 2.31[2][a] use the following example (which has been modified by this explanation):
Bettco Company, SA, a Brazilian corporation, engages in business in a number of unrelated fields. For the last few years, it has sold vintage wines throughout the world, including, on infrequent occasions, the United States. Although title to the wine passes upon acceptance of the buyer in the United States with the result that the income is from U.S. sources, Bettco has been properly classified as a passive investor taxpayer because its contacts with the United States are not sufficiently broad to cause Bettco to be doing business in the United States.

Hence, since Bettco is not engaged in business in the United States and since its income from U.S. sources is not FDAP, none of Bettco’s income has been subject to federal income tax under IRC Reg. 1.1441-2(a)(3).

In 1995, Bettco opens an office in the United States for the purpose of assembling and selling certain radio components Bettco manufactures in Brazil. Bettco thereby begins to engage in business in the United States. As a result, even though the sales of wine have nothing at all to do with Bettco's U.S. office, the income from sales of the wine in the U.S. will be taxed at ordinary income rates, despite the fact that the wine sales are not conducted in the U.S. because the presence of Bettco's office in the U.S. makes all U.S. source income (which is not FDAP income) ECI.
Based on IRC § 864(c)(3) as illustrated by the above example, if Parent conducts any business through Sub or branch office, or through an agent, all U.S. source income will be ECI. Therefore, under Example II, Parent will have to file a U.S. tax return by virtue of its operations in the U.S. This result will occur even if the U.S. Sub or branch office was engaged in a business that was wholly unrelated to the sale of screens to Compac.

D. Activities of an Agent

In Situation B, Parent will use ACME as its agent to warehouse its screens and to provide shipment of those screens under the principles of JIT inventory. When a foreign corporation employs an agent to do acts that would be considered an effective trade or business if the foreign corporation had performed those acts through a subsidiary or branch office, the Parent will be considered ETB. Therefore, the agent's acts are attributed to the Parent for purposes of determining whether the Parent is ETB. This is the result even if the Parent has never been physically present within the U.S.

When the agent is employed to sell goods or products in the U.S., the FC generally holds title to the goods until they are sold and, therefore, it is the FC which is ETB. If, however, the agent is acting on behalf of the buyer and title passes outside the U.S., there would be no agency relationship between the FC and agent. Also, if FC establishes a distributorship with its subsidiary under an independent and arm's length relationship, the FC will not be ETB. Handfield v. CM, 23 TC 633 (1955), Private Letter Ruling 7931056.

In Private Letter Ruling 7909063, the IRS found that a foreign corporation which sold goods exclusively outside the U.S., and which formed a subsidiary to maintain an inventory of its goods in a warehouse, provided general accounting operations relating to the inventory, received payments from customers and paid all expenses relating to the operation of the facility, was not an effective trade or business. This ruling determined that the warehousing and accounting of goods in the U.S. was not a material factor in the sale of such goods since all sales occurred outside the U.S. The ruling substantiates the conclusion that operation of a warehouse to maintain an inventory of goods in the U.S. for sale in the U.S., will cause Parent to be ETB and will subject it to U.S. taxation.

In Situation B, ACME's activities with respect to JIT will cause Parent to be ETB in the U.S. This result will occur whether or not Parent has an office or employees located in the U.S. Direct sales made by Parent to its customers in which title to the screens is transferred to Compac outside the U.S., and in which ACME merely clears the shipment through customs, will not cause Parent to become ETB.

E. Observations and Suggestions

1. Use of ACME to perform JIT inventory functions or otherwise operate on Parent’s behalf with respect to the sales of screens in the U.S., will cause any foreign corporation to become ETB and will subject its effectively connected incom to U.S. income tax at graduated rates.

2. If goods are sold by Parent directly to U.S. customers in which title passes outside the U.S. and in which ACME merely provides customs brokerage services to Parent, Parent will not be ETB and no U.S. taxes will be owed.

3. Even if Parent sells goods directly to U.S. customers under Paragraph 2 above, if Parent has an office, employees or uses an agent to represent it in the U.S., it will be ETB in the U.S., and all of its U.S. source income will be ECI, even if the goods sold have no relation to the business activities in the U.S.

4. The payment of U.S. taxes may be minimal since the Parent is entitled to the same deductions as any domestic corporation would receive under the U.S. tax code, and its taxable income will be taxed at graduated rates, starting at 15%. Therefore, if the Sub can generate sales of 20% or more, the U.S. tax will be offset by the increased sales. Also, all the Sub's expenses can be deducted from any taxable income generated by the sales of the screens. Furthermore, the profit attributable to the sale of the screens could be reduced by allocating indirect expenses, such as general overhead, interest costs and R&D costs, to the cost of producing the screens.

5. The transaction might be restructured so that ACME does not engage in significant business activities on behalf of Parent in the U.S. If JIT inventorying of the screens could be performed: (i) In another country (possibly Mexico or Canada, depending on how those countries would treat the warehousing of goods destined to the U.S.); or (2) by ACME, as agent for the purchaser, in which the purchaser took title to the screens overseas, but ACME warehoused the screens for purchaser in the U.S., Parent might avoid ETB status under Example I.

September 13, 2008

The situation is actually significantly worse than the mere bailout of Fannie, Freddie, and the FDIC would suggest, once one places the bailouts in their proper historical and political contexts.

This article by Don Rich for the Ludwig von Mises Institute is an excellent and concise summary of where we are today and why. Rich notes that there are fundamental disequilibria between the U.S. government's promised spending versus expected revenues and between American living standards and economic productivity. Through the use of the fiat money system and with the help -- sometimes head-scratch inducing -- of China, Japan, and Russia, among others, the U.S. has been able to defer having to deal with those disequilibria, while financing a worldwide military empire. More frequent and worse financial crises suggest this game cannot go on much longer.

If Ludwig von Mises were to peruse today's newspapers, he would recognize the symptoms of a worldwide central-bank-generated credit bubble and its oncoming collapse. What increasingly characterizes the global financial order, Mises would say, is an arrangement where regulators encourage a "heads I win, tails everyone else loses" mentality, backstopped by the willingness of quasi-governmental entities to print and borrow money without bound.

A gentle man by all accounts, Mises would resist the temptation to say, "I told you so," and focus on how to avoid a full-blown global economic and political catastrophe.

The announcement by the FDIC that it might have to "temporarily" borrow money from the Treasury, i.e., the taxpayers, is the latest squawking canary that the dollar-centric global-fiat-money and regulatory era in place since World War II is approaching a final ugly dénouement.

The FDIC now fails to meet its required statutory minimum of 1.15% of capital per insured dollar in deposits due to the ongoing mortgage and credit market carnage; hence the hint for the life preserver thrown out by the FDIC to the Treasury Department the last week of August 2008.

The FDIC, like Fannie and Freddie, says, "Of course we will pay this loan back when everything returns to normal." The accounting "profession" and "civil servants" at the CBO et al are likely to give their seal of approval to an FDIC bailout with the assurance that "all is well" in the short run. In fact, the bailouts of Fannie, Freddie, and the FDIC in the long run by themselves are likely to be as effective as the Niedermeyer character from the movie Animal House was in attempting to stop the John Belushi–triggered stampeding crowd at the end, pitifully screaming, "Remain calm, all is well."

As in the case of Fannie and Freddie, the FDIC promise to repay the taxpayers when things return to normal is worthless, because there was nothing normal about the real estate and associated credit bubble in the first place. The FDIC, Fannie and Freddie will assure everyone that "the public will receive its money back when the assets of failed banks, etc. ... are sold." That is unhelpful nonsense.

By definition, a bubble is an economic disequilibrium caused by the excessive creation of money in relation to the intrinsic value of the asset class to which the money is drawn. In long-run equilibrium, therefore, the money stock (and therefore asset prices) must return to their productively useful value in relation to the size of economic output, or the general price level must rise to restore the fundamental relationships between the marginal utilities of goods and their prices: Mises 101.

In other words, in the case of the fallout from the real-estate and associated credit bubbles, either housing and bond prices must fall dramatically, or there must be a dramatic increase in inflation, or a combination of the two. This is not rocket science, whatever the sophists of the political class would have us believe.

Without wishing to cause a panic, the situation is actually significantly worse than the mere bailout of Fannie, Freddie, and the FDIC would suggest, once one places the bailouts in their proper historical and political contexts.

For the last 60 years, the United States has provided military protection for the European and Asian capitalist powers, all possessing economies governed by regulatory apparatuses analogous in character to the apparatuses of the American postwar New Deal. These apparatuses, especially when coupled to fiat money, have in common the fundamental flaw that they create economic instability via moral hazard.

This provision of American military protection has been supported by the imperial tribute of the acceptance of paper dollars -- dollars at first theoretically backed by gold. Of course, this charade, described by Robert Triffin in 1960, ended in 1971 with the collapse of the Breton Woods system, exposing holders of dollars to massive losses and causing the Great Inflation of the 1970s.

Through the 1970s and 1980s, the U.S. did not abandon the course of empire, or statist regulation, but instead expanded, especially the imperial side of the interventionist mentality and especially in the wake of the collapse of the Soviet Union. Whatever the deregulation of other sectors of the economy, the financial sector -- due to its role in imperial finance -- retained its peculiar regulatory privilege through its ability to generate unlimited losses at taxpayer or dollar-holder expense.

This expanded American empire was, for a time, bizarrely aided by the People's Republic of China as part of an industrialization policy in which the Chinese sterilized the purchase of dollars by massive domestic security sales to soak up excess liquidity. This is a strategy that is rapidly running out of steam and has created a dangerous inflation in Chinese real-estate and stock prices that is unlikely to end well.

Japan, capitalist-oriented East Asian and to a lesser degree Western central banks, the oil states, and Russia (yes, Russia) also purchased huge quantities of dollar-denominated assets from the 1990s onwards, with the effect of subsidizing the Pax Americana -- probably because alternative security arrangements seemed more expensive. Alas, that willingness to subsidize the United States would seem to be rapidly waning. Russia's recent assertiveness is a hint of things to come, as more and more foreigners are taking a hard look at their subsidization of an America living beyond its means. The stocktaking economic signal globally is the increasingly punishing foreign-credit-related losses caused by the Fed's last imperial bubble, a credit bubble that has infected the entire planet.

It was fun for the U.S. in the short and medium run, since, at least in the 1980s, it got to have its imperial cake and shopping-mart icing too. The United States thereby avoided having to deal with the fundamental disequilibrium between both the federal government's promised expenses versus expected revenues, as well as the associated disequilibrium between American living standards and economic productivity.

That era is coming to a close, with the increasing amplitude in the financial oscillations of the world economy at lower frequencies, demonstrating systemic instability dating, at the latest, to the Asian financial crisis of 1998.

In response to that crisis and to concerns over Y2K, and with especially intense initiation at the time of the LTCM fiasco (an event itself of course made possible by the intrinsic moral hazard of Greenspan and the postwar regulatory mentality), the Fed lowered rates, thereby pushing the tech-stock bubble into a final frenzy. Raising rates in 1999 to combat Fed-fiat-money generated inflation, the creature from Jekyll Island succeeded in crushing the NASDAQ et al, and, in the process, generating a global economic downturn.

In 2002, now concerned about deflation, the Fed took rates to absurdly low levels, thereby generating the housing bubble. Worried about inflation in 2006, in which the housing bubble was the inevitable consequence of trying to maintain American asset prices and output valuation at nonequilibrium levels, Greenspan's fall guy Bernanke took rates up, killing the housing bubble, and then took rates down while revving up the printing presses to stave off a credit-market collapse. This leads us to the current juncture with Fannie, Freddie, and the FDIC, and what Mises would clearly identify as the "policy" trap.

Viewed in isolation, the Fed can take rates neither substantially up nor down. If it fights its own inflation by taking rates up, it sends the economy into a depression. If it fights a credit-contraction-generated recession with lower rates, it risks a hyperinflation and a run on the dollar. If the federal government were to try to use any more fiscal stimulus on the tax or spending side, the Ricardian equivalence theorem would apply to an entity with a present discounted budget deficit/solvency problem of $30 trillion dollars. That is, there will be minimal effect. A bump in second-quarter GDP changes nothing about the long-run picture, and in equilibrium actually means merely a shift of output from the future to the present. It is, however, popular with politicians under the electoral gun and Wall Street types looking for suckers.

In other words, Mises would point to the bailouts of Fannie, Freddie, and the FDIC as the hint that a general system event had arrived, in which we need a new policy mentality. Mises would clearly see the solution to the fiat-money-generated world disequilibrium as a global return to a commodity-money standard with 100% reserve banking as the only monetary policy rule and a banking order that avoids the disequilibria generated by the politically motivated manipulation of the money supply.

Although the author was trained in a very different mentality, he now sees an irreducible truth in the argument that, under the current discretionary monetary policy arrangements, we keep observing the same cycles in under and overextension of credit, because the political temptation to do so is overwhelming. In the long run, when monetary authorities around the globe play the same game -- and especially when the use of that credit is so often indirectly used to finance war -- the results of central-bank activities are likely to be so poor in terms of system risk that the seemingly radical step of a return to commodity-based money and a new reserve order for the banking system might well be the most responsible step to take, provided that the move is done in an orderly fashion.

Given the need to avoid an implosion of the world political order, such a transition would probably have to be created in conjunction with negotiations with our foreign creditors for a new gold-based monetary order to avoid a panicked run on the dollar, amid attempts to attack a grossly overextended American imperial position. In the regulatory field, what is needed at a minimum is the effective creation of an adults-only area where losses are credibly understood as not subject to a Greenspan-like put in order to permanently rid ourselves of the "heads I win tails you lose" financial-system externality that is getting increasingly expensive and disruptive.

Although this analysis of the meaning of the FDIC bailout in its broader consequences cannot be regarded as cheery -- and, to some, may seem radical -- human beings do poorly when imitating ostriches, and any of the alternatives available to policy makers are likely to be gratuitously destructive in character.

September 10, 2008

Add up overt and hidden military expenditures ... The sum is backbreaking for a nation in decline, but the public knows neither that it is backbreaking nor that the country is in decline.

Fred Reed encapsulates the Gordian knot that must be untangled for the United States to revive itself economically: The American military budget represents money the U.S. cannot spend to become more competitive. But too many political interests -- jobs, military-dependent towns, and corporate profits -- depend on the budget. Moreover, the American public is not even aware of the burden on the American standard of living imposed by military spending. And the spending rolls on despite the American military being unsuitably outfitted to intervene in today's conflicts (if that were a good idea, which it is not).

Expect the economic decline to continue until a crisis forces a change, all while the politicians continue to promise both guns and butter.

I wonder whether the United States had not ought to re-ponder the place of the military in society and in the world. There is not the slightest chance that this will happen, but wondering has not yet been forbidden. It appears to me that bureaucratic clotting set in years back, and is now having its effect in spheres martial. A robust economy can afford frivolities that one in derobustion cannot. And that is where America is.

The U.S. military is the military of World War II, but with better technology. The Navy still consists of carriers surrounded by ships intended to protect the carriers. The heart of the army is still armored and infantry divisions with artillery and close-air support. The Air Force too. All are designed to fight enemies like themselves. However, there are no enemies like themselves, and WWII forces do not well fight the enemies they do have, such as ragtag dispersed guerrillas, because they are not intended to fight them.

Why a World War II military? Because of institutional inertia, because men delight in fast, powerful things that make loud and stirring noises, because the ships and tanks and submarines are magnificent. Relinquishing them is too painful to contemplate. Instead of changing its forces to suit present needs, the Pentagon keeps them as they are and tries to use them where they do not work well.

WWII militaries are intended to destroy expensive point targets and to conquer crucial territory. For example, they try to destroy the enemy's aircraft and conquer his cities. This America does very well indeed. The difficulty is that dispersed guerrillas do not have any expensive point targets, crucial territory, or cities. The Pentagon is using baseball bats to fight mosquitoes. The absurdity of using a B1 intercontinental bomber for close air support is manifest. But you have got the plane, the pilots do not want to miss the war, and so you find something for them to bomb.

A current American weakness is that it has a small army. Controlling large countries full of dispersed enemies requires large armies. America's is a small army because it is an All Volunteer army. Not many young men want to be soldiers. The Pentagon likes the All-Vol for two reasons. First, volunteer soldiers are much better than unwilling short-term conscriptees. Second, the public does not care if volunteers get killed. After all, they volunteered. They come from blue-collar families. These regard the death of a son as a noble sacrifice rather than a human sacrifice for large commercial firms. And they have little political influence anyway.

This matters. The Pentagon has learned that it cannot sustain a war in the face of united public opposition. If students in college were drafted, hell would follow. The key is not to disturb the public, which the military recognizes as more of a danger than the enemy actually being fought.

The true enemy, always, is the press. Should reporters turn against a war, they would rouse that great sleeping Public Monster, and then the military would face a war on two fronts. Fortunately the press consists of a few large corporations and holding companies owned by people of the same social class, who are not opposed to the current wars.

Since World War II, political power has become increasingly concentrated in the presidency, the concentration having become very rapid in recent years. Most crucially, the Congress has relinquished its power to decide whether the country goes to war. Thus wars are no longer determined by the national interest but by presidential whim. These whims can be directed by the desires of the president's friends, by powerful groups with agendas, by writers at intellectual magazines. Quite often these know nothing of war. And the military by enshrining obedience avoids responsibility.

The U.S. is phenomenally if discreetly militarized. The country is neither a democracy, nor a government of laws, nor of men, but an oligarchy of lobbies that press for whatever is of benefit to themselves, though not necessarily to the country. The underlying principle is that honey attracts flies. The federal government collects vast sums in taxes and the lobbies come to get it.

In the military racket, the money is in big-ticket weaponry. The carriers, Aegis boats, subs, fighters, tanks, B1s, B2s, and satellites sell for billions. These sums attract a vast aerospace industry that would collapse without sales to the military. The Pentagon is a captive market, and often a haven for firms that could not compete in the commercial marketplace.

Much of this money goes for pricey gear that is both unknown to the public and of little use for the wars the country fights (but probably should not). To hide a program from the public, you do not have to make it secret, which would only draw attention. Just don't talk about it. The press, which is owned by big business and manned by reporters of preternatural technical puzzlement, will say little. For examples, search on JSF, F22, V22, ABL, and ABM.

As always, the key is to avoid waking the public. Thus the military avoids attention. But add up overt and hidden military expenditure: the "defense" budget, appropriations for the wars, the black programs, the Veterans Administration, the national laboratories, TSA, and so on. The sum is backbreaking for a nation in decline, but the public knows neither that it is backbreaking nor that the country is in decline.

To countries competing with the U.S., as for example Japan, the American military budget is a godsend, the equivalent of a golf handicap on a rival, because it represents money the U.S. cannot spend to become more competitive. Fortunately for Asia, American military expenditure cannot readily be cut back. Too many jobs, military towns, and corporate profits depend on it. Consequently China builds infrastructure while the U.S. builds fighter planes. The only plausible brake will be conflict with Social Security and Medicare, cuts in which will wake the Public Monster.

The illusion of omnipotence dies hard. The American military has been dominant for so long that neither it nor Americans can grasp that there are limits to its power. America now tries militarily to encircle Russia, Iran, and China, which increasingly looks like an aging pit bull trying to encircle a herd of moose. The Pentagon is planning for a war with China and talks of "Full Spectrum Dominance." The current government in Washington wants to attack Iran and Pakistan, threatens Syria and Venezuela, and seems bent on igniting another Cold War with Russia (if one ignites cold wars). The Army is to be expanded.

Meanwhile China builds infrastructure.

September 19, 2008

The effects of these actions represents a seismic shift in the history of this country.

The big story this week of course has been the major earthquake that hit Wall Street and the world financial markets. Tremors and widening fissures had been observed for weeks, months, and years. Some had been warning of such a happening for decades. But it is not a stretch to characterize this week's events as the equivalent of "the big one" finally arriving.

We cannot completely blame the fiasco on government. Politicians can have a cliff constructed using stolen funds where once there was a gentle slope, but they cannot really force all the lemmings to go charging off it. And yet, they were responsible for the cliff.

So how did the policy makers react? Exactly as we and other pessimists have been predicting. Certain well-connected lemmings were rescued. In the process bagfuls of sand were thrown into the gears of the economic and financial system. Our capacity to recover from all the poor decisions made heretofore has been impaired in a major way. And the new policies will almost certainly guarantee that the crisis will get worse, perhaps after a deceptive remission.

"I can calculate the motions of the heavenly bodies, but not the madness of people," said Sir Isaac Newton, reacting to the South Seas Bubble frenzy that engulfed Great Britain in 1720. Alas Sir Isaac himself -- one of the great geniuses to have graced this world -- could not refrain from joining the fun, and sustained a £20,000 loss when he turned out to be the greater fool to whom the lesser fools were selling. Almost 300 years later we observe no diminishment in the madness of people, although we think that it is harder for geniuses to obtain an audience. And a look at the franchise granted to the South Seas Company reveals that governments will ever look for a way to get something for nothing.

We were attracted to this article -- posted on Minyanville, a "financial infotainment ®" site -- from among tens of hundreds of others providing commentary on the same subject because we found the headline metaphor so utterly appropriate. Naturally, we will have much more to say as the march down the road to serfdom continues. Be prepared to hang on to your assets with both hands, folks.

A week ago, the United States had the most efficient capital allocation system in the world.

Our free-market economy enabled money, credit and resources to be sent to the economic players who needed it. Entrepreneurs could raise money to start new, innovative businesses. Researchers could seek out cures for diseases that touch millions of lives, as well as those that afflict just thousands. Firms that made enough bad decisions went bankrupt.

The job of regulators was to ensure the system functioned and to set up rules by which honest business could be conducted. It was not a perfect system, but it was better than the alternative.

This is the alternative.

When government invades free markets to the extent it has -- specifically in the last 24 hours -- the system ensuring capital gets where it needs to be breaks down. Money is instead doled out to the firms well connected enough in Washington to lobby for handouts.

Beltway bureaucrats have been trying to rewrite this country's economic rules and protect Wall Street from its own mistakes for over a year. Still, the free market prevailed, punishing the firms that made the most egregious bets during the housing boom: Countrywide, Bear Stearns, IndyMac, Merrill Lynch, AIG, Lehman Brothers, National City, Washington Mutual ("WaMu") and Wachovia.

According to our once-free market, these firms needed to be wiped out, gobbled up and liquidated, so real economic growth could take hold from a stronger foundation.

This morning (Friday), we heard many claim the government's actions -- temporarily banning short selling, the creation of a Treasury Department distressed-asset hedge fund, the establishment of a federal backstop for money markets, to name but a few -- were necessary to prevent a wider financial and economic crisis. The shortsightedness of this argument is astounding.

A couple hundred years ago, Charles Darwin opined that nature has long been engaged in weeding out the weak, protecting the strong. This natural ebb and flow of dominance according to a given species' inherent characteristics has governed the world's socioeconomic landscape for more than 4 billion years.

The actions taken overnight seem to refute Darwin's claim that Mother Nature can manage her own backyard. Adam Smith's invisible hand is capitalist Darwinism, moving the weak aside so the strong can survive.

To take that power away from the market is tantamount to shoving God aside and rewriting the evolutionary playbook.

The effects of these actions, this fundamental ideological shift from capitalism towards socialism, represents a seismic shift in the history of this country. The events of the past week -- and what it says about our collective ability to take our lumps, drink our medicine and recognize that the path to the ultimate goal is one littered with hairpin turns and drop away cliffs -- will not be lost on future generations.

The events of the upcoming months and years, whether we are content to continue to hand over more and more power to the few, elected and non-elected alike, will show the true mettle of the American spirit.

September 15, 2008

New rules will impose tax on expatriates and withholding requirements on trustees.

The land of the free has joined those historical regimes well known for their respect for individual liberties, Nazi Germany and Soviet Russia, in imposing an exit tax on citizens who choose to give up their U.S. citizenship and exatriate. Such a tax had been proposed multiple times over the years, but failed to become law until this past June.

The new law mandates that unrealized gains on the qualifying expat's worldwide assets be calculated, and any gains in excess of $600,000 be added to taxable income. Such assets include interests in grantor trusts, as defined by the tax code, whose existence as independent legal entities are basically ignored for purposes of the act. The $600,000 doubles to $1.2 million for a married couple filing jointly, and will be inflation indexed going forward. Details are covered below.

Mark Nestmann points out possible unpleasant effects of the new law here. His metaphor that the idea is to "keep the slaves on the plantation" sums up our sentiments as well. We would add that the planation is tottering financially, and requires all the funds it can grab to delay the day of reckoning.

Welcome to the Hotel California. ... You can check out any time you like, but you can never leave!” ~~ The Eagles

Giving up a U.S. passport will soon carry a steep price tag. A new law passed by the U.S. Congress and sent to the President will subject certain individuals who expatriate or give up their green cards to immediate tax on the inherent gain on all of their worldwide assets and a tax on future gifts or bequests made to a U.S. citizen or resident.

Tax practitioners had been made to feel like the boy who cried wolf in recent months as the U.S. Congress repeatedly threatened to enact legislation aimed at U.S. citizens who expatriate. Congress finally made good on those threats by unanimously passing the Heroes Earning Assistance and Relief Tax (HEART) Act (the 'Act'), which provides tax relief for active duty military personnel and reservists.

The new tax regime applies to certain individuals who relinquish their U.S. citizenship and certain long-term U.S. residents (i.e., green card holders) who terminate their U.S. residence (hereafter referred to as 'expatriates'). The so-called 'mark-to-market' tax will apply to the net unrealized gain on the expatriate's worldwide assets as if such property were sold (the 'deemed sale') for its fair market value on the day before the expatriation date. Any net gain on this deemed sale in excess of $600,000 will be taxable.

In addition, trustees of (U.S. and non-U.S.) non-grantor trusts must withhold and pay over to the IRS 30% of the portion of any distribution (whether direct or indirect) that would have been taxable to the expatriate had he not expatriated. Failure to withhold the tax could subject the trustee to direct liability for the unpaid U.S. tax.

Individuals Covered

The Act applies to any expatriate if that individual (i) has a net worth of US$2 million or more; (ii) has an average net U.S. income tax liability of greater than US$139,000 for the five year period prior to expatriation; or (iii) fails to certify that he has complied with all U.S. federal tax obligations for the preceding five years (the 'covered expatriate').

The Act contains two exceptions, which are broader than those contained in current law. An individual is not a 'covered expatriate' if he certifies compliance with U.S. federal tax obligations as specified in item (iii) above, and: (i) he was at birth a citizen of the U.S. and another country, provided that (a) as of the expatriation he continues to be a citizen of, and a tax resident of, such other country, and (b) he has been a resident of the U.S. for no more than 10 of the 15 taxable years ending with the taxable year of expatriation; or (ii) he relinquished U.S. citizenship before reaching the age of 18 1/2, provided that he was a resident of the U.S. for not more than 10 taxable years before relinquishment.

The Act consists of three key elements:
  1. The mark-to-market tax on the covered expatriate's worldwide assets;
  2. A tax on certain gifts and bequests made by the covered expatriate to any US person; and
  3. A repeal of the current so-called 10-year shadow period for covered expatriates.
As noted above, the mark-to-market tax will apply to the net unrealized gain on the covered expatriate's worldwide assets as if such property were sold for its fair market value on the day before the expatriation date to the extent that the net gain exceeds US$600,000.

However, the mark-to-market tax will not apply to (i) certain deferred compensation items; (ii) certain specified tax deferred accounts; or (iii) any interest in a nongrantor trust.

A. Deferred Compensation Items

Under the Act, certain deferred compensation items will be subject to the mark-to-market tax. For purposes of this calculation, the covered expatriate is deemed to receive the present value of his accrued benefit on the day before the expatriation date. No early distribution excise tax applies by virtue of this treatment, and appropriate adjustments must be made to subsequent distributions from the plan to reflect such treatment.

Other qualifying deferred compensation items will not be subject to the mark-to-market tax; however, the payor must deduct and withhold a tax of 30% from any taxable payment to a covered expatriate. A taxable payment is subject to withholding to the extent it would be included in the gross income of the covered expatriate if such person were a U.S. citizen or resident.

B. Specified Tax Deferred Accounts

Under the Act, the mark-to-market tax will apply to certain specified tax deferred accounts. In the case of any interest in a specified account held by a covered expatriate on the day before the expatriation date, the expatriate is deemed to receive a distribution of his entire interest in the account on that date. Appropriate adjustments are made for subsequent distributions to take into account this treatment. Such deemed distributions are not subject to additional tax.

C. Interests in Non-Grantor Trusts

The Act makes a distinction between grantor trusts and non-grantor trusts. A grantor trust is ignored as a taxable entity for U.S. federal income tax purposes. The "owner" of a grantor trust must include in computing his personal tax liability the items of income, deduction and credit that are attributable to the trust. Therefore, in the case of the portion of any trust for which the covered expatriate is treated as the owner under the grantor trust provisions, the assets held by that portion of the trust are subject to the mark-to-market tax.

The mark-to-market tax does not generally apply to non-grantor trusts. Rather, in the case of any direct or indirect distribution from the trust to a covered expatriate, the trustee must deduct and withhold an amount equal to 30% of the distribution portion that would be includable in the gross income of the covered expatriate if he were subject to U.S. income tax. The covered expatriate waives any right to claim a reduction in withholding under any treaty with the U.S. The Act does not explain how the withholding will be enforced against a non-U.S. trustee of a trust.

In addition, if the non-grantor trust distributes appreciated property to a covered expatriate, the trust recognizes gain as if the property were sold to the expatriate at its fair market value.

If a non-grantor trust becomes a grantor trust of which the covered expatriate is treated as the owner, such conversion is treated as a distribution to the covered expatriate and will trigger the 30% withholding tax.

Conversely, if a grantor trust becomes a non-grantor trust after the individual expatriates, it appears that the mark-to-market tax will apply to assets in the grantor trust, and the 30% withholding requirement will not apply to the trust once it becomes a non-grantor trust. This is an important point because the grantor's expatriation commonly converts grantor trusts into non-grantor trusts.

Tax on Gifts and Bequests to U.S. Citizens or Residents

The Act taxes certain "covered gifts or bequests" received by a U.S. citizen or resident. The tax, which is assessed at the highest marginal estate or gift tax rate at the time of the gift or bequest, applies only to the extent that the covered gift or bequest exceeds $12,000 during any calendar year. The tax is reduced by the amount of any gift or estate tax paid to a foreign country with respect to such covered gift or bequest. No allowance appears to exist for the $1 million exemption from U.S. gift tax or the $2 million exemption from U.S. estate tax normally granted to U.S. persons. Gifts or bequests made to a U.S. spouse or a qualified charity are not subject to the tax.

In the case of a covered gift or bequest made to a U.S. trust, the tax applies as if the trust were a U.S. citizen, and the trust is required to pay the tax. In the case of a covered gift or bequest made to a foreign trust, the tax applies to any distribution, whether from income or corpus, made from such trust to a recipient that is a U.S. citizen or resident in the same manner as if such distribution were a covered gift or bequest.

Current law subjects expatriates to a so-called 10-year shadow period, which results in a covered expatriate being taxed as a U.S. citizen in any of the 10 years following expatriation in which the expatriate spends 30 days in more in the U.S. In addition, current law taxes expatriates on all U.S. source income and gain during the shadow period.

Under the Act, individuals who expatriate on or after the date of enactment will not be subject to the shadow period but will instead be subject to the mark-to-market tax and the tax on gifts and bequests to U.S. citizens and residents. ...

In light of the Act, individuals who are considering expatriation should consider the substantial new tax burdens that this action will generate. Those persons who expatriate after the enactment date and who are considering making gifts or bequests to U.S. persons in the future should also review their planning. In addition, trustees should very carefully consider whether trust beneficiaries are covered expatriates before making any distribution without withholding U.S. tax. Trustees who fail to become familiar with the new rules do so at their peril.

September 19, 2008

Foreign currency trading has traditionally been limited to those with large amounts of capital to trade, or those willing to use major leverage in order to trade the minimum sized forex contracts. No longer. Exchange traded funds (ETFs) have invaded this domain, and one can participate in small-sized forex trades without using leverage. This useful article serves as a good introduction to the arena.

After looking like it was on a fast track to zero the first half of this year, the U.S. dollar rebounded dramatically over the last few months. The PowerShares U.S. Dollar Index Bullish Fund ETF (symbol UUP) rose from under 22 at its July low to almost 26 earlier this month -- a 17%+ trough to peak rise, which roughly mirrors the the euro's decline from $1.60 to under $1.40 over the same period. This is obviously not as exciting as if you had traded using 10-1 leverage with a forex broker, but if you got the intermediate trend right and sat still you made a nice return while sleeping at night.

Now it looks like the USD's bull move may be at the very least taking a breather. The mind can come up with all kinds of "reasons" why it should be weaker -- especially this week -- but markets do what they do because they do it over shorter time frames. What Benjamin Graham said of the stock market can be said of financial markets in general: In the short run they are voting machines; in the long run they are scales.

Our point is that there are now no contraints on your capacity to trade on the basis of your foreign currency convictions. The price of entry is low if you use a no-frills online broker, and the risk is easy to manage. For those who want to be heavy in cash right now, the question is cash in which currency? Almost any solution will have a corresponding ETF that can be used to implement it.

Whether you know it or not, you are probably investing in foreign currencies now. If you own an ETF or mutual fund in any international equity or fixed income product, you are taking a currency risk. It is not an indirect risk; it is as direct as it gets. Foreign holdings are priced in their native currencies, and every price movement is captured in the dollar denominated net asset value [NAV].

Even if you sell your foreign assets and invest only in American firms, you do not escape exposure. On average, large American firms do about 30% of their business in the international sphere. Their profits are immediately affected by movements in the currency markets. You cannot escape currency risks, but you can be aware of them, and you can do something to accommodate them.

The first line of defense against unhealthy currency risks is to make sure your portfolio is fully diversified in its international holdings. This spreads your currency exposure as widely as possible. Just as in stocks and bonds, where diversity is of utmost importance, the same applies to currencies and all other asset classes you own.

For many investors, just making sure your international holdings are well diversified is probably enough to reduce the currency risks to an acceptable level. But, you may want to add additional currencies to your portfolio, because there are substantial benefits derived from doing so. The most widely acknowledged benefit is the low correlation that currencies have with virtually all other classes. This feature of currenices is unique in its level of non-correlation. Other asset classes claim to be of low correlation (real estate, bonds, emerging markets for example), but when the correlations are quantified, currencies stand far above all others.

Just ask yourself, since early November of 2007 when equity markets began their slide, wouldn't it have been great to have assets in your portfolio that actually increased in value over the period? Would that help you keep on course for achieving your financial goals? It is easy to talk "buy and hold," but it is not so easy to actually stick to your guns when your investments drop by 20% or 30% in a steep market slide. This kind of market sends investors panicking to the sell window just when they should be standing fast.

Currency investing may provide just the cushion you need during rough periods, helping you to stay the course. And staying in the game is what it is all about; you cannot win if you do not play. If you panic and sell during the lowest periods, then you will be buying back at higher prices later -- buying high and selling low. Not what the doctor ordered.

If you decide to take a second step and buy currencies directly, you will discover some of the other properties of Forex (Foreign Exchange Currency) trading: first, currencies may actually make money for you by appreciating in price, and secondly, you will earn interest on your foreign currency holdings.

In Forex trading, a strategy that seeks to buy currencies that are expected to rise in price is called a "value strategy," and it is no different than your expectations that some equities are undervalued. If your analysis tells you that the Chinese Yuan, for example, is undervalued, then buy the Yuan. It is available in an ETF (CYB) (from WisdomTree) or in an ETN (CNY) (from Van Eck/Morgan Stanley). If you are right, you will profit from the Yuan's rise. If not, you will at least experience the second benefit from owning a foreign currency -- you will earn interest on your investment. This comes about because the banks that hold the currency you bought use your investment deposit to purchase commercial and government-issued short-term interest bearing investments.

So, while you are technically holding currency, you are actually holding short-term debt obligations denominated in the currency you bought. When the debt instrument matures, the interest owed is paid and passed on to you. With the Yuan and most other emerging market currencies, where it is often difficult to find local short-term deposit possibilities, the fund managers use futures contracts that accomplish roughly the same thing -- you profit from receiving the differential between the spot price and the forward contract price. Either way, you earn something on your holdings.

This feature of earning interest on the currency you own is a significant strategy for making money on foreign exchange investments. It is called the "carry trade," and is responsible for trillions of dollars of currency trading. But, it is also possible you may incur a loss if the price of your currency falls during the time you were earning interest. This possibility makes holding foreign currencies different from holding U.S. dollars in a money market account. Money market funds are managed to keep a constant value -- not difficult since there is no chance of the dollar falling in dollar value.

But when your money crosses an international border, the currency risk raises its head. This is a good reason not to engage in the carry trade -- you might lose. Although currencies usually have lower volatility than equities, there are still risks. You must be comfortable that you want to take the risks and that you can afford the potential losses that may result from currency investing.

Once you have decided to allocate an appropriate amount to currencies in your portfolio, then the fun begins. Now you can choose among all the currencies available for trading, and the list is getting longer every month. This is a good thing, in my view, for not too long ago, if you wanted to hold Forex, you had to open a special trading account with one of the online trading brokers. It is a fast-moving, wild and wooly environment, highly leveraged, where fortunes are made and lost on an hourly basis. This is not suitable for most investors, especially those who have lives outside the Forex arena.

Fortunately, a new kind of ETF and ETN has been recently introduced that allows an average individual investor to buy a fairly good range of currencies. There are currently about 12 pairs available, and additional pairs can be bought if you select one of the bundled exchange-traded products. Speaking of pairs, do not be put-off by this terminology. In fact, one cannot speak of the dollar rising or falling without referencing another currency. The dollar cannot rise or fall in relation to itself; it can only change with respect to some other currency. Neither can any other currency. So, when you buy Mexican Pesos in the U.S., you are borrowing dollars from yourself and investing them in Pesos. You own a currency pair: U.S. Dollar/Mexican Peso. If you were in London and bought Pesos, your pair would be the Pound Sterling/Mexican Peso.

I am going to post these lists in two groups: individual currency ETFs or ETNs, and bundled currencies of both formats.

Individual Currency Products: Bundled Currencies Products: In lieu of recommendations, let me leave you with disclosure on my current holdings: BZF, FXM, JEM and UUP. If you will read through the currency posts I have made over the last year at Seeking Alpha, you will get a good idea of why I have chosen these products. But, I do not recommend others necessarily follow suit. My rationale is: the first two are individual carry trade holdings that pay high interest rates. The second two are bundles to give my portfolio more diversity and earn some interest; JEM holds 15 emerging markets currencies and pays a good dividend. UUP holds the G10 currencies doubled up with leverage for the bullish dollar -- strictly a value play.

I also keep tight limits on currencies as a percentage of my total portfolio. This year I have gradually allowed my allocation to be just under 15%. This is toward the high end of most recommendations. But this is a new area of investing, indeed, as all alternative asset classes are, and there is no consensus in the financial advisor community about it. Some do not recommend any, some recommend more. Use your best judgment to keep the risks balanced and within your comfort zone.

You should support any decision you make with the full knowledge of the risks involved and a thorough investigation on your own about each possible investment. There are good reasons to own foreign currencies. There are also good reasons not to own them. Good luck!

E Pluribus Hokum or when the Gamblers Bail Out the Casino
September 22, 2008

An invitation to abuse of power unparalleled in American history, in which ill-paid civil servants will set prices on the portfolios of the banking system with no oversight and no threat of legal penalty.

The mysterious writer "Spengler," named after German historian and philosopher Oswald Spengler (1880-1936) whose best known work is the book The Decline of the West, is an extremely erudite fellow whose articles regularly show up in Asia Times. His ruminations range from economics to politics, from international affairs to religion, from philosphy to (appropriately) the decline and fall of Western Civilization. A la Ghandi, one presumes he thinks the later would be a good idea.

In this piece Spengler fixes in his gunsight on the vital but largely ignored party to the ongoing financial fiasco, the American taxpayer -- who consequently emerges bullet-ridden from the encounter. Americans have been so feckless with regard to managing their personal financial affairs, he maintains, that they figure they may as well gamble on the fixes proposed by Paulson et al, however much of a longshot it is. Like Kris Kristofferson and Janis Joplin's Bobby McGee, they are free because they have nothing left to lose. Collectively it cannot possibly work; but for some individuals it might. That, and the inherent incomprehensibility of the situation, is why Americans are offering so little resistance to sacrificing their children to the fat cats.

A theory of what drives this double-or-nothing mentality has recently been codified in a book Spengler cites, A World of Chance, which he thinks highly enough of to recommend -- seriously, we think -- that the authors receive the economics Nobel Prize. He concludes with this telling but intriguing question: Where is America's Vladimir Putin equivalent, who will drive out the oligarchs who stolen the country's wealth and debased its currency?

Why should American taxpayers give U.S. Treasury Secretary "Hank" Paulson a blank check to bail out the shareholders of busted banks? Why should the Treasury turn itself into a toxic waste dump for their bad loans? Why not let other banks join the unlamented Brothers Lehman in bankruptcy court, and start a new bank with taxpayers' money? Or have the Treasury pay interest on delinquent mortgages, and make them whole? Even better, why not let the Chinese, or the Saudis or other foreign investors take control of failed American banks? They have got the money, and they gladly would pay a premium for an inside seat at the American table.

None of the above will occur. America will give between $700-$800 billion to the Treasury to buy any bank assets it wants, on any terms, with no possible legal recourse. It is an invitation to abuse of power unparalleled in American history, in which ill-paid civil servants will set prices on the portfolios of the banking system with no oversight and no threat of legal penalty.

Why are the voices raised in protest so shrill and few? Why will Americans fall on their fountain-pens for their bankers? If America is to adopt socialism, why not have socialism for the poor, rather than for the rich? Why should American households that earn $50,000 a year subsidize Goldman Sachs partners who earn $5 million a year?

Believe it or not, there is a rational explanation, and quite in keeping with America's national motto, E pluribus hokum. Part of the problem is that Wall Street, like the ethnic godfather in the old joke, has made America an offer it cannot understand. The collapsing the mortgage-backed securities market embodies a degree of complexity that mystifies the average policy wonk. But that is a lesser, superficial side of the story.

Paulson's dreadful scheme will become law, because Americans love their bankers. The bankers enable their collective gambling habit. Think of America as a town with one casino, in which the only economic activity is gambling. Most people lose, but the casino keeps lending them more money to play. Eventually, of course, the casino must go bankrupt. At this point, the townspeople people vote to tax themselves in order to bail out the casino. Collectively, the gamblers cannot help but lose. Individually they nonetheless hope to win their way out of the hole.

Americans are so deep in the hole that they might as well keep putting borrowed quarters into the one-armed bandit. They have hardly saved anything for the past 10 years. Instead, they counted on capital gains to replace the retirement savings they never put aside, first in tech stocks, then in houses. That has not worked out. The S&P 500 Index of American equities today is worth what it was in 1997, after adjusting for inflation (and a pensioner who sells stock purchased in 1997 will pay a 20% capital gains tax on an illusory inflationary gain of 40%). Home prices doubled between 1997 and 2007 before falling by more than 20%, with no floor in sight.

As it is, many of the baby boomers now on the verge of retirement will spend their declining years working at Wal-Mart or McDonalds rather than cruising the Caribbean. Some of them still have time to tighten their belts and save 10% of their income (by consuming 10% less), plus a good deal more to compensate for the missing savings of the 1990s. ...

The homeowners of America hope against hope that somehow, sometime, the price of their one only asset will bounce back. ... Sadly, there is no reason to expect the bailout of bank shareholders to have any effect at all on American home prices, which will continue to sink into the sand. ...

For the Paulson bailout to be helpful to the banks, it must buy their securities at much higher prices than the private market is willing to pay. Otherwise it makes no sense at all, for the banks could sell at any moment to the hedge funds. But that is a subsidy to private banks, administered at the whim of the Treasury Secretary, without oversight and without the possibility of legal recourse. ... Opposition to the Treasury plan is disturbingly thin. ...

Why the taxpayers of America would allow their pockets to be picked in this fashion requires a different sort of explanation than one finds in economics textbooks. My analogy of gamblers taxing themselves to bail out the casino is inspired, in part, by a remarkable new book by the Canadian economists Reuven and Gabrielle Brenner (with Aaron Brown), A World of Chance. In effect, the Brenners reinterpret economic theory in terms of gambling, showing how profoundly gambling figures into human behavior, especially in such matters as so-called life-cycle investing. The 50-ish householder who has not made enough to retire may take outsized chances, considering that as matters stand, he will work until he drops dead in any case. ...

A World of Chance undermines our usual view of "economic man" and substitutes the angst-ridden, uncertain denizen of a world that offers no certainties and requires risk-taking as a matter of survival. I hope to offer a proper review of the work in the near future. As my marker, though, permit me to leave the thought that for providing a theoretical foundation for the counter-intuitive behavior of American taxpayers, the Brenners deserve the Nobel Prize in economics.

Alas for the gamblers of America: they will tax themselves to keep the casino in operation, but it will not profit them. Where, oh where, is America's Vladimir Putin, who will drive out the oligarchs who have stolen the country's treasure and debased its currency?

September 22, 2008

The masters of the universe began to believe their own grotesque guff, sewing the seeds of their downfall.

Pride goeth before the fall, the age-old proverb informs (informeth?) us. Once the fall actually commences we might expect, or hope, that the pride that preceded and facilitated it might departeth through the nearest door. No sign of that so far, we regret to inform you. The U.S. empire is in a decline that is obvious to all but the most deluded -- which comprises 80% of the U.S. population and 99% of the politicians, but we digress -- yet the chest-puffing coming out of Washington has never been higher. The U.S. has had almost 20 years, since the fall of the Iron Curtain, to cultivate the art of humility from a position of strength. Having missed that chance, and cultivated the art of hubris instead, it is about to have humility thrust upon it.

The U.S. investment banks (Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns) -- the masters of the universe, this cycle's "smartest guys in the room" -- made buckets of money creating and selling toxic financial sludge which made "high yield" scams look prudent by comparison. At least with HYIPs you can surmise you are dealing with a Ponzi scam and try to get out before the scheme folds. The investment banks succeeded in hiding this fact from themselves. In the equivalent of Charles Ponzi invested his and his wife's cash into his own scam, they reinvested their profits in the very crap they created. We are well-warned about the dangers of believing our own press clippings, but, pace Will Rogers and Charlie Munger, some people learn by reading, a few learn learn by observation, and some people just have to piss on the electric fence.

The U.S. investment banking industry bull market in humility has been dynamic indeed. Two of the five (Bear, Lehman) are kuput. Merrill sold itself while the going was still half good. Morgan and Goldman were transformed into bank holding companies this past weekend. Their swinging bachelor days have ended. Meanwhile, some strange "conservation of hubris" law seems to be in effect. Ben Bernanke and Hank Paulson act as if they can actually save the system from its past malfeasances. This is about as likely as Wile E. Coyote finally catching the Road Runner. Yes, this time my Acme whatchamacallit will catch the critter. He won't get away this time!

Amidst this mess, who wins the award for dumbest man in America? Bill Bonner has trouble choosing a winner. We would vote for the whole United States. If we were forced to choose just one, then Paulson, who led Goldman down the derivatives garden path and now believes he is the man to clean up the mess, gets our vote. Extra points for being dangerously stupid, having not been humbled yet.

Where did he go wrong? The question probably crossed his mind ... perhaps even when he mounted the scaffold on January 21, 1793. The Bourbons had been the most successful family in Europe. They had ruled Europe's biggest and richest country since Henry IV. And now they were on thrones all over Europe. But in the language of the City, Louis 16th blew himself up. He was supposed to be an absolute monarch. Ah ... there was the dynamite! He believed it. He had surrounded the Parliament with troops and turned the country against him. And now, he had absolutely no control over anything. Not even the power to save his own skin.

"Sire, you have committed something worse than a crime; you have committed an error," Talleyrand might have told him. Poor Louis! He already had the bag over his head. And the blade at his neck. He must have felt like the dumbest man in France.

Dick Fuld must have felt pretty dumb too. His firm had survived the Civil War, the Railroad Bankruptcies of the late 19th century, the Bankers' Panic of 1907, the Crash of 1929, the Great Depression, WWII, the Cold War. Lehman Bros. had outlasted spats, prohibition and disco music. But it could not keep its head through the biggest financial boom in history.

John Edwards, recently claimed the title of the "dumbest man in America," when the press got wind that he was two-timing his wife and running for president at the same time. But Edwards has more competition every day. By Monday of this week (last week), Fuld had completely destroyed Lehman Bros. In January of 2007, the financial industry put a value on the firm -- a company it knew well -- of $48 billion. This week, the bid went to zero. And then, on Wednesday, came more disquieting news: the world's largest insurance company, AIG, was failing. Martin Sullivan had run it into the ground, said the analysts. Now, it needed an $85 billion bailout.

There was no one there to bail out Louis when he needed it. France was not too big to fail; it was too big to bail out. And everything had been going so well! When Jacques Turgot was Controller-General, he was getting rid of the internal customs barriers, lifting price controls, abolishing the trade guilds and the corvee (the system of forced labor used to build roads). The political system was being reformed too -- evolving towards a parliamentary democracy.

But along came those plucky Americans to stir up trouble. They sucked France into war with Britain. France supplied money, materiel and troops -- landing 5,000 soldiers in Rhode Island and ultimately winning the war by blockading Lord Cornwallis at Yorktown.

"The first shot will drive the state to bankruptcy," Turgot warned the king. He was right. By 1786, the French were in desperate straits, with half the population of Paris unemployed and a national debt equal to 80% of GDP. The French were counting on the Americans to begin repaying their $7 million in loans, but the United States was broke too. And soon, French credit was so bad, the king could no longer borrow from the moneylenders in Amsterdam nor even from his own creditors in Paris. Having borrowed too much, Louis no longer had any room to maneuver. All he could do was to march up the scaffold steps like a real monarch.

And now the heads roll on Wall Street. James Cayne at Bear Stearns. Stanley O'Neal at Merrill Lynch. Charles Prince of Citigroup. But who is the dumbest? Surely Dan Mudd and Dick Syron at Fannie and Freddie are still in the running. Even with the deck stacked in their favor, they could not stay in the game. And let us not forget the rescuers -- Ben Bernanke and Hank Paulson. They have practically nationalized not only America's mortgage industry, but, taking an 80% stake in AIG, the insurance industry too! Where does the money come from? It is borrowed too -- hundreds of billions worth. Surely, there is a guillotine waiting for them somewhere.

The last 15 years have been too kind to finance. Wall Street and the City are essentially debt mongers; and in the boom, nobody did not want to borrow. Financial profits soared. Since 1980 the profits of the U.S. financial sector as a portion of GDP have gone up 200%. Industry owners and managers could have taken their money off the table and retired to Greenwich. But on the back of this outsize success grew a monstrous hump of self-delusion. The masters of the universe began to believe their own grotesque guff. The financial markets were perfect, said the academics. All-knowing and all-seeing, they would not make a mistake. And the chiefs at the big financial firm must have thought they supped with the gods themselves. They had the paychecks to prove it.

Of course, some Wall Street bosses were more cunning than others. In selling itself to Bank of America, for example, Merrill Lynch dodges the scaffold; but it becomes a ward of the state, almost like Fannie and Freddie before they were kidnapped outright. Bank of America has easy access to Fed funds. Merrill figures it might need more money too.

The old regime on Wall Street was dominated by just five large investment companies. But the more they talked their own books, they more they came to think it was true -- they were all too big, too smart and too rich to fail. Not only did they package and sell explosive packages of debt, they put the stuff in their own vaults too. Now, Lehman, Bear, and Merrill have blown themselves up. Only two more to go.

And now they have gone, in all but name.

September 27, 2008

The creation of the credit bubble was one of the most disgraceful episodes of economic government in western history. But that does not mean the ship is lost.

Ambrose Evans-Pritchard takes a look at the various and sundry dollar-collapse forecasts, and takes a pass ... for now. He thinks the other major currencies are in even worse shape, as hard as that may be to believe. Soon enough this will be gold, he believes, but not until it is clear that every central bank will be cranking up the presses.

This just arrived in my e-mail from Alex Patelis, global strategist at Merrill Lynch.

Taking Stock

* Treasury buying mortgage-related assets: $700 billion

* Potential supplementary stimulus package favoured by Democrats: $100 billion

* Insuring money market funds: $50 billion

* Treasury fortifying the Fed's balance sheet: $100 billion

* Expansion of temporary swap lines with central banks: $180 billion

* Loan to AIG: $85 billion

* Fed purchase of agency discount notes & ABCP: amount not specified

* Fed loans through the Primary Dealer Credit Facility: $20 billion through Sept 17

* Fed's discount window: $33 billion balance

* Treasury purchase of GSE MBS this month: $10 billion

* Potential cost of Fannie/Freddie bailout: $200-$300 billion

* Financing the current account deficit: priceless

Investment Implications


"The fiscal cost to the United States is likely to be enormous. Speculation will intensify on a possible U.S. government paper downgrade. U.S. policy-making and credibility has been put into question. The safety of U.S. assets has been put into question. We remain concerned with the repercussions that this crisis will have on the financial flows into the United States against the context of a still large current account deficit."

Mr. Patelis has come within a whisker of warning that the U.S. now faces a full-scale run on its currency and debt markets. There is certainly a risk that this could happen.

By my tally, the serial bail-outs add $1.6 trillion to total U.S. debt, or 12% of GDP, (at least on paper). This is worse than the Swedish banking collapse in the early 1990s.

An entire generation of American policy-makers -- Clinton, Bush, Rubin, Greenspan, and the Congressional leadership of both parties -- has come perilously close to ruining a great nation. The creation of the credit bubble was one of the most disgraceful episodes of economic government in western history.

Nothing can justify it. There is no parallel to the Spain of Phillip II, who ruined his empire to pursue the religious cause of Counter-Reformation, or to the bankruptcy of the British Empire combating fascism. It occurred because America abandoned all restraint and gave licence to consumer hedonism.

Having said that, I still believe that the U.S. has the cultural vitality to pull itself out of this debacle.

While I endorse Mr. Patelis's indictment, I do not entirely share his conclusions. The debt added is backed by collateral, mostly housing, and is therefore nothing like normal government debt.

Even if it were, the U.S. general government debt (owed to the public, under IMF measures) would rise from 48% to 60% of GDP. Yes, I know the U.S. "national debt" is higher, but that is not the relevant benchmark for worldwide comparisons.

This extra debt is a tax on the future. It is unconscionable, but it is not a catastrophe. It would still leave U.S. debt at French or German levels, and well below those of Japan and Italy -- assuming you believe the official figures.

I do not think it will come to this. The RTC made a profit in the early 1990s as the Savings and Loan crisis slowly abated. Paulson's "TARP" may do likewise. The ABX index used to price subprime debt almost certainly overstates the likely default rate.

Stephen Jen, currency chief at Morgan Stanley, says bank crises are bloody for currencies, but nationalizations of the banking system (which is what we have here, in disguised form) typically mark the bottom.

I do not share the widespread view that the dollar will collapse. This has prompted a volley of hostile comment, as if I was somehow turning traitor to the cause of bears, or had become an optimist overnight.

The reason why it will not collapse -- at least for now -- is that the euro is facing an even deeper and more intractable crisis, Britain is mangled, Sweden frozen, most of Eastern Europe is facing a swing from property boom to bust, Brazil is about to slow dramatically, Japan is in full-recession, and China's banking systems is buckling, as Fitch warned today (September 23).

What I envisage as this credit crisis goes turns into a full-fledged global economic slump is that half the world resorts to currency devaluation in a beggar-thy-neighbor scramble to stave off recession and cling to market share.

This will be very good for gold, though only once the EMU smash-up becomes more evident, perhaps with the onset of street protests in Spain. You will not have to wait very long.

To those GATA loyalists asking me why I never report on their claim that the gold price is manipulated by central banks, I can only say that it would be a full-time job to attempt to verify such assertions. I cannot judge whether China, Japan, Russia, emerging Asia, or the Mid-East petro-powers are colluding in such practices, or ascertain why they would do so. And unless they collude, any unilateral efforts by the U.S. to suppress gold would prove futile -- would it not?

September 29, 2008

Lew Rockwell, eponymous publisher of LewRockwell.com, declared the (temporary, we now know) defeat of the bailout bill, which he called "the most horrible and outrageous bill to ever come before Congress," to be a glorious act for liberty and "the worst days in decades for the power elite" -- "the Fed, the Treasury, leadership of the Democrats and Republicans, the Wall Street Journal and the New York Times, all the major think tanks, most talking heads, the wealthiest corporations, important academics."

Indeed. Let us appreciate the victories as they come, however fleeting. Each ridiculous ripoff rammed through the Washington law-mill is another nail in the coffin of their legitimacy.

I am fully aware that Paulson and Bernanke have some nefarious scheme in mind to reverse the thrilling defeat of their criminal bailout package, a package shot down by independent members of Congress on both sides. But reflect for a few minutes on what it means that the House did this. It was a revolutionary act in the best sense of that term.

The entire establishment was united in favor of what was surely the most horrible and outrageous bill to ever come before Congress. The Fed, the Treasury, leadership of the Democrats and Republicans, the Wall Street Journal and the New York Times, all the major think tanks, most talking heads, the wealthiest corporations, important academics -- in short, the whole of the power elite -- were united in favor of this awful thing that proposed the following: Americans were to be stripped of their earnings and their future to prop up failed enterprises.

Forget back-door socialism. This was right through the front door. The consequences would have been dreadful and very scary. It was to be the first of many bailouts, since of course it cannot and would not work. Bad debts cannot be made good by legislation. This means that more money would be necessary, as the middle class was sucked dry by the vampire state for years to come. Deeper and deeper economic depression -- a repeat of the 30s -- was certain. Best to put a stop to this now.

The administration might have tried to do its wicked deeds through executive order rather than asking Congress. But there are two problems here. One is that they would not be able to share the blame when the plan flops. The other is economic. The Fed and Treasury are actually very worried that they are incapable of injecting more credit into a banking structure averse to lending right now. They would rather have the congress authorize the money directly and run up the debt.

In any case, no matter how you look at it, the defeat of the bill is a victory for freedom. The defeat of the power elite is essential for liberty to thrive. For the free market to function, we need the government/corporate cabal to lose its capacity to get its way in every area of life. They need to feel fear. They need to lose security. They need to have a sense of uncertainty as to whether their every wish is our command. The House defeat of the bailout is a magnificent rebuke in that sense.

But does it mean that the economy is going to tank and we will all suffer? On the contrary, it could mean that we can begin an economic recovery from the Fed-generated bubble that should have and would have burst years ago but for artificial props by the Fed. If the stock prices of these troubled institutions can fall to where they need to be, they can be taken over, and their assets used productively and traded by the market. Once this deleveraging takes place, we will be ready for a new round of economic growth.

You have to understand how ridiculous this whole debate looks to anyone who understands the price system. Let's change the example from houses to apples to see how silly it is to suggest that falling prices can be made to rise. Say that the Fed created an apple hysteria that drove the price from $3 per pound to $10. Stores loaded up and even used them as collateral for expansion. Suddenly the price collapsed to $5 and finally to $2.

Now government takes notice. What can government do to deal with the problem? It can try to boost the price of apples by forcing stores to raise their prices. But what about consumers? They will not buy at $10. So the apples sit and rot. Maybe government should buy them all or force consumers to buy them. Also perhaps stores will just not buy any more at all. Government could force them to. But it cannot force them to stay in business. People can always walk away. So perhaps government can just buy the stores, all in the interest of keeping the price of apples up. But it will have to buy the apple-leveraged stores at a much higher price than the market would offer, so this is a bad economic deal on the face of it.

The tangles can get ever more complicated and billions and trillions can be spent. You can put everyone in a prison camp and force people at the point of a gun to buy and sell apples at $10. But in the end, the problem is still the same: The price of apples wants to fall. Nothing government does changes that one fact. To attempt to change it is like trying to change gravity. Of course, the government's central bank can raise all prices through inflation to the point that apples do in fact cost $10, but this is purely cosmetic. In fact, in real terms, the price of apples is still $2. It is a pointless and destructive activity to try changing this. You only cause massive damage in the attempt.

More great things happened after the bailout failed. Commodity prices including oil fell dramatically. This is a magnificent thing. Right now, consumers are not threatened by the possible failure of another paper-addicted investment-banking house. Consumers are threatened by ever-higher prices for all goods. If we are in a recession, especially if it lasts and lasts, low prices are precisely what we need to start economic recovery again.

It is not entirely clear why prices fall. It could be the worldwide economic slowdown. It could be that the markets are beginning to doubt the capacity of the Fed to actually achieve the hyperinflation that it wants, since banks have become quite risk averse. In any case, we need ever-lower prices on all things, including gas and groceries -- and, yes, houses. This is the basis for economic recovery.

The failure of the bailout bill was the precondition for economic recovery. It should make believers in liberty realize that we can change history, that tyranny is not our fate, that the leviathan state can be beaten back.

Recently we have urged readers to look to books on money and banking. Now it is time to look at books like the Discourse on Voluntary Servitude by 17th century French writer Étienne de La Boétie. It was his view that the state is the least plausible institution on earth, one that would be overthrown in a day but for propaganda and ideological error. He explained all this in his book, introduced by Murray Rothbard. We just so happen to have a new edition out.

Yesterday was one of the worst days in decades for the power elite. It was one of the best for liberty.

October 2, 2008

Chris Floyd briefly revels over the power elite's humiliation from the failure on Monday to pass the bailout bill, thanks to a comatose population actually waking up temporarily and making its voice heard: "[I]t is good to see the icy beads of panic dotting the brows of elites who have inflicted and/or countenanced so much death, destruction, terror and degradation in the past few years. Today they have suffered a very rare defeat in the relentless, remorseless class war they have been waging against us for decades. And that is something to celebrate -- at least for one night."

The vote by the House of Representatives to defeat the Wall Street bailout plan is the first act of political courage that the Congress of the United States has mounted in the last seven years. The fact that it was due largely to right-wing Republicans afraid of going down with the sinking ship of the witless leader they have followed blindly throughout his reign is a delicious irony -- but the whys and wherefores of the vote are not important. What matters is that one of America's moribund institutions has flickered to life long enough to derail a disastrous action that would have shoved the nation even deeper into the pit of corruption and ruin where it has been mired for so long.

The New York Times called the House vote "a catastrophic political defeat for President Bush, who had put the full weight of the White House behind the measure." But this is manifestly untrue. As everyone but the nation's media -- and the Democratic Party -- knows, George W. Bush has no "political weight" to use, or lose. Yes, he still retains the authoritarian powers that the spineless Democrats have given him with scarcely a whimper of protest (and often with boundless enthusiasm); but as a political force, i.e., someone whose opinions and statements can sway popular opinion, he has been a dead and rotting carcass for a long time. He is the most unpopular president in American history; and I can report from first-hand, eyewitness knowledge that he is thoroughly despised by some of the most rock-ribbed, Bible-believing, flag-waving, down-home, John Wayne-loving Heartland types that you can imagine. Even his own party -- a party fashioned in his own image, the Frankensteinian melding of willfully ignorant religious primitivism and rapaciously greedy crony capitalism that he has embodied in his twerpish person -- kept him away from their convention this year.

Nothing -- absolutely nothing -- could be politically safer than opposing George W. Bush. And yet the entire Democratic leadership, Barack Obama included, lined up to support a cockamamie plan proposed by this scorned and shriveled figure, a plan that was transparently nothing more than an audacious raid on the Treasury by Big Money hoods and yet another authoritarian power grab by a gang of murderous, torturing, warmongering toadies. This was the plan and these were the people that the Democrats decided to fight for.

What is more, the Democrats stood shoulder to shoulder with the president on what is apparently the only issue that can now stir Americans to genuine anger and widespread protest: a direct threat to their bank accounts. Wars of aggression like the Nazis used to wage, elaborate tortures like the KGB used to practice, concentration camps, lawbreaking leaders, diminishment of liberty, the slaughter of a million innocent people in a land destroyed by an illegal and pointless invasion -- all of that stuff is pretty much OK, easily swallowable, worth no more than a shrug or perhaps a frowny "tsk tsk" before going on to the sports pages or flipping over to another channel. But put out an open ploy to steal their money and give it to the filthy rich -- and baby, it's pitchfork time! Yet here, as the public face of just such a ploy, is where the Democrats chose to make their stand.

So Monday's rejection of the bailout plan is not a catastrophic political defeat for George W. Bush. He has no political standing, no political future. But it is a vast and humiliating defeat for the Democratic leadership, across the board, who, as Democrat Lloyd Dogget of Texas said:
... "never seriously considered any alternative" to the administration's plan, and had only barely modified what they were given. He criticized the plan for handing over sweeping new powers to an administration that he said was to blame for allowing the crisis to develop in the first place.
Now the Democratic elites have had their collective head handed to them on a platter. It is a dish most richly deserved. And although it is almost possible to believe that they will learn anything from this episode, there is now a chance -- a chance -- that we can at least have a discussion of alternatives to the Bush scheme.

I still believe it is unlikely any genuinely effective program -- one that could manage and mitigate the now-unavoidable effects of the Wall Street/Washington-induced disaster -- will ever get enacted. After all, the Democrats are largely owned by the same corrupt and greedy elites now seeking a handout. And it seems reasonable to assume that the Bipartisan Bailout Bunch will eventually find some kind of sugar to tempt away the two dozen votes they need for their next "compromise" on the Bush-Paulson plan.

Then again, who knows? There are obviously a lot of very powerful and privileged people sweating more bullets tonight than they have sweated in many and many a year. They have roused the drowsy beast of popular anger at last, and no one can say what might happen next. Probably nothing -- or rather, more of the same, in some form or another. But still, it is good to see the icy beads of panic dotting the brows of elites who have inflicted and/or countenanced so much death, destruction, terror and degradation in the past few years. Today they have suffered a very rare defeat in the relentless, remorseless class war they have been waging against us for decades. And that is something to celebrate -- at least for one night.