W.I.L. Offshore News Digest for Week of October 27, 2008

CHINA’S NEW LANDED GENTRY: FOREIGNERS

In theory and in law, China provides very little protection for property rights. In practice, there are three levels of protection – foreigners get the most, peasants the least.

Economic growth is strongly correlated with the rule of law, i.e., consistent and objective enforcement of property rights and other contracts, freedom from arbitrary decrees imposed by those ranging from petty bureaucrats on up to the upper reaches of government (hello, Mr. Putin), and a non-stifling regulatory regime. So how to explain China, with its absolute rule by a central committee which has been historically headed by the likes of Mao? For one, it turns out that no foreigner investor has had property expropriated during the past 50 years.

Such cannot be said for the Chinese peasants. It is a situation analogous to Western governments who offer big tax breaks to attract wealthy and mobile expats while heavily burdening their local, immobile, peasant equivalents. The Chinese know the foreigners can go elsewhere, and treat them accordingly. But the peasants are starting to rebell. Some are rioting. Whether this forces institutional change is an open question.

Most experts on economic growth agree that the rule of law -- with secure property rights, enforcement of contracts, and freedom from regulation and special privilege favoring one group over others -- are important prerequisites for prosperity. This makes China, in the eyes of most, an exception.

Since the mid-1980s, an estimated 40 million peasant farmers have had their land expropriated for commercial development, for a tiny fraction of the land's value. The Washington-based Property Rights Alliance constructed an International Property Rights Index last year, ranking China 46th of 70 countries, right after Colombia. The Wall Street Journal's 2008 "Index of Economic Freedom" also ranks China well toward the bottom, 126th on a list of 165, with its lowest score (ranking at the 20th percentile) in the area of property rights.

Yet China's economy has boomed, and foreign direct investment continues to pour into the country, rising from $2 billion in 1990 to $90 billion in 2007. This raises a compelling question: Why are foreign investors taking such risks without secure property rights? What makes China different?

The answer is that China is not different. Its economic growth has depended upon a property-rights system with varying degrees of security. There appears to be a 3-tier system of property rights, depending on where the property is located and who owns it. Peasant farmers have the least protection, city residents have better protection, and foreign investors have the most secure property rights.

There has not been a single case of a foreigner investor losing property during the past 50 years. Foreigners have developed a high level of trust with the Chinese. Foreigners often build in rural areas, but they do not negotiate with individual farmers over the purchase of land, since farmers work under the auspices of so-called Town Village Enterprises.

A TVE is a land collective that lets farmers receive the fruit of their labors, but decides from year to year how land will be allocated. The mayors or managers of the TVEs are directed by China's central government to be self-supporting. No one expects government bailouts from Beijing.

Town Village Enterprises act as if they were for-profit corporations, with peasants in the role of de facto employees, rather than property owners. TVEs compete with each other in wooing foreign investors, promising them tax breaks and land. A foreign company can generate far more tax revenue and many more jobs than a rice-paddy farmer.

The property-rights system is thus centered on the interlocking relationship between the TVE and the foreign investor, and it has worked with a brutish efficiency that has not been thwarted by special interests, such as environmental or health organizations, or by labor unions. Foreign investors rely on TVEs to enforce land rights, while TVEs depend on foreigners for tax revenue. This goes far to explain why foreign companies do not hesitate to invest in China and have few worries about losing their investment by government expropriation.

China nurtures this relationship for other good reasons as well. Although laborers in China's foreign-owned companies make up only 3% of the workforce, they are eight times more productive, and contribute some 40% of overall GDP growth, according to a 2006 analysis published by the National Bureau of Economic Research.

Yet the plight of the peasant farmer is becoming increasingly hard for China to ignore. It is not uncommon for a farmer to discover bulldozers readying his land for a new factory. His compensation, perhaps $5,000, is a fraction of the hundreds of thousands of dollars that the Town Village Enterprise may receive from the foreign investor for rights to the property. The displaced farmer must then find a job in the city or at the factory. Across the countryside, peasant farmers are more openly rebelling against such actions, and anger is rising. Last year, farmers led 80,000 riots or protests.

The property-rights protections for city dwellers are significantly greater. City residents often receive a special designation, known as "urban dweller" status. Upon getting this designation, a city resident may enter into the housing market and purchase a long-term lease (typically 70 years) on a property. Such leases are fully transferable and can be used as collateral for borrowing. Although city dwellers are still subject to eminent-domain types of land claims, they must be compensated with fair market value, or allowed to buy property at another, similar location. Perhaps the government recognizes, from a pure profit-motive perspective, that there is far more to lose by expropriating, say, office buildings, rather than rice paddies. The potential for foreign-capital flight would be very high indeed.

China's version of protection for property rights is different from the Western model, but it does the job: Business investors are provided security from expropriation. While the current system efficiently fuels China's growth, it remains to be seen how long China can trample peasant farmers rights in order to achieve its economic goals.

TROUBLE IN PARADISE

Costa Rica is a retirement heaven – unless some squatters steal your land.

Costa Rica has a notorious reputation for not protecting the property rights of foreigners, especially in the countryside where squatters can occupy untended land when the land owner is away and then be very hard to evict. The World Bank recently ranked Costa Rica 164 out of 181 economies in the world for protecting investors, so this is not just hearsay based on odd cases. This piece from Forbes provides a gallery of examples of exactly such instances. It is caveat emptor in spades.

This is the deeper lesson we take away: If your wealth visibly exceeds those of the people that surround you, plan on being a target. The mechanisms for theft take different forms in different countries, but always to the same end. It is human nature that the large holdings of rich landlords -- especially foreign landlords who are away a good part of the year -- will be inviting targets for the poor and landless. Beware of this wherever you might move. Personally, we would not live any place in a manner where our lifestyle sticks out. It just seems like common sense.

The check from Banco de Costa Rica for $157,202 cleared in August. But after 12 years of legal wrangling it was not much consolation to H. Craig Carter and a small group of investors from Utah, who had hoped to turn their 180 acres in this Central American Shangri-la into luxury condos. In 1993 the group paid $50,000 for the dirt in hopes of spending another $12 million to develop Rincón Golf & Country Club Community. "They are not giving us a fair price on the land we own," insists Carter, 78, who with his associates has spent an additional $200,000 on travel and court fees. Based on the rise of property values in Costa Rica's Guanacaste Province, he argues the plot is worth $4 million and is hoping for additional compensation.

Good luck. Today the place is occupied by 20 families of squatters, a series of tin-roof shacks and small plots of corn and beans hemmed in by barbed wire. Carter and his group, HEC Estados de Flora, won a suit in 1997 affirming ownership. But squatters -- claiming the land had not been continuously occupied -- appealed to the Institute for Agrarian Development, which expropriated the property "by virtue of the public interest." For decades the Costa Rican government has encouraged homesteading to cultivate land and thereby reduce poverty.

Welcome to Eden -- after the fall. An estimated 50,000 Americans and 15,000 Canadians spend more than four months a year in Costa Rica, a tiny, peaceful democracy (population 4 million) with heart-stoppingly beautiful mountains, rain forests and beaches. Every year 2 million visitors pump $2 billion into a stable economy.

It may be a great place to visit, but as a retirement spot? Think hard -- particularly as an absentee landlord. The agrarian law says that squatters cannot be booted off unoccupied land without a court order. Moreover, if they stick around for a year they get the right to stay indefinitely, if no one evicts them, and after 10 years of such de facto possession they can file for title on the land.

The World Bank ranks Costa Rica #164 out of 181 economies, alongside Iran and Haiti, for protecting investors.

There is not much recourse for owners who encounter uninvited guests. They can sue based on recorded title, but cases can drag on for years. As far as protecting investors, the World Bank ranks Costa Rica near the bottom -- number 164 out of 181 economies -- alongside Iran, Senegal and Haiti.

Many landowners simply give up. Max Dalton did not. A decade ago Dalton, 78, complained to the U.S. Embassy and the Costa Rican authorities about squatters before a confrontation with a dozen campesinos on property he had bought near Pavones in the southwest. In the resulting shootout, he and one of the protesters died. The case provoked a U.S. congressional resolution and pressure on the Costa Rican government to tighten protection of property rights.

Yet ownership remains as sketchy as ever. Jean Marie Meadows, a 55-year-old massage therapist from Inglis, Florida, bought two parcels five years ago for $50,000. Turned out that one property was on public park land and the other belonged to Californian Daniel Fowlie, a felon convicted of drug charges, who himself has spent years trying to get back 3,000 acres he bought in the 1970s. When Meadows pressed the real estate agent about the problem, she says, he sold her another parcel, which, after she left Costa Rica, was apparently sold to someone else. "It is the most beautiful place I have ever seen," says Meadows, who intended to raise her kids in Pavones. "But do not buy property there. The land has been bought and sold many times."

It sounds like there is a need for American-style title insurance here. Since that is a staple of property buying in America we find it surprising that people would proceed without such an assurance in a distant market.

Miguel Angel Ortiz Morales, 66, lives in an open-air shack, lit by candles in tuna cans, on land that HEC's Carter says once belonged to his group. "If it had been occupied, we would not have entered," Ortiz insists. Ortiz surely is not blind to the possibility of making a tidy profit in Guanacaste, where vans labeled turismo cruise the dusty back roads. "A house on this hill, looking at that," Ortiz says pointing to a view of Rincón de la Vieja Volcano National Park. "How beautiful would that be?"

Robert Sprague, 65, retired six years ago from a job as Latin America senior analyst at the U.S. military's Southern Command in Miami. In 1982 he bought 2.5 acres of rolling pasture in Escazú, a San José suburb. Since then, Sprague says, he has kept up on the property tax (0.25% of recorded value) and visited often. To keep off intruders, he lets a family live on his land in a wood shack. "Being an Intel type you are always leery of something," he says. (Former Intel head Andy Grove wrote a book titled Only the Paranoid Survive.) "Then, all of a sudden, a little rat slips through the back door and shorts out the whole system."

As Escazú became an incorporated, ritzy locale for foreigners and embassy residences, real estate values soared. When Sprague readied to sell in February, he discovered the property had already been sold. The land registry pointed to a document in which he had supposedly signed over power of attorney authorizing the sale -- and a receipt claiming he had been paid $300,000 for the land. Sprague says the documents are fake and his signature is forged. His civil and criminal suits are pending.

Title insurance would not usually defend against that.

No one is immune to land grabs -- not even large companies. In 2001, 600 or so squatters invaded a 2,000-acre bamboo farm owned by Standard Fruit Co. de Costa Rica, a wholly owned subsidiary of the privately held Dole Food (2007 sales: $7 billion). Standard Fruit found out and immediately pounced, evicting some squatters five times. Dozens of them fled to the San José cathedral, where they staged demonstrations for weeks. The company hired a former Supreme Court judge, an authority on agrarian law. Still, the fight lasted seven years. "The law prevailed at the end," says Juan Carlos Rojas Zeldón, head of legal affairs for Standard Fruit. "It cost a lot of money" -- $5 million, by one estimate, for land worth roughly $10 million -- "but the company wanted to defend the property."

Some properties, including those on the Pacific Coast boomtown of Playa Herradura, have become too valuable not to defend. Over the last decade sprawling developments like Los Sueños Resort & Marina, where even the stop signs are in English, have mushroomed. A 5,000-square-foot house recently sold for $1.3 million. Everything but the cemetery seems to be for sale. Hillsides have been razed for residential and commercial projects. Strip malls bulge with U.S. franchises like Pizza Hut.

In the 1970s Herradura was just farmland near a pristine beach. Then expats, mainly from California, bought 60 or so 12-acre lots for around $30,000 apiece. The land was supposed to be cultivated as a giant mango and avocado cooperative, but that did not happen. Many original buyers stopped visiting; some never did. In 1989 squatters appeared, planted their own crops and started raising families. When the guard overseeing the land made a complaint to police 10 months later, he claimed that it had been a violent takeover. But, complicating matters, the squatters accuse the guard of selling off pieces of the foreign-owned property. (He denies the accusation.)

Today the 700 acres "belong" to squatters and to 3rd- and 4th-time buyers. Carlos Umaña Umaña, one of the original squatters, sold pieces to people like Jorge Robles, an accountant from San José who wanted a weekend getaway. His 1992 contract says Umaña was a peaceful farmer and sold the land on the authority of 3 1/2 years of possession rights. Now Robles and his wife have retired there, enjoying the fruits of their orchard, if not of legitimacy. A sign at the end of their long grassy driveway reads "Paradise."

Many of the California owners wrote off the properties as losses. Others, as land values jumped, kept trying to reappropriate their assets -- with little to show for it. "Every Tom, Dick and Harry is jumping in on this thing," says Sheldon Haseltine, 61, of Clinton Corners, New York, who is making common cause with five other original buyers. Over a decade of Kafkaesque legal entanglements, he has tried repeatedly to pin down people like Umaña, the squatter. In addition to selling to Robles years ago, Umaña last year unloaded some land to Armando González Fonseca, president of an AMPM convenience store franchise and a Citibank Costa Rica board member, who is filing for title of the land through Umaña's original squatter claim. González says it is perfectly kosher, since the former owners left and did not come back. "The guy I bought from, he stayed for 20 years, and he used this land for things like cows and farming." If Haseltine has an issue with that, González opines, he should file a complaint and stop harassing him. (Haseltine has dragged his complaints to Citibank, which says it is looking into questions of unethical practices but has found no wrongdoing and considers it a private matter.)

Larry W. Long, 61, a Canadian who sells real estate in Costa Rica, last year sold his 3 acres of land in Herradura for $90,000. That is three times what he paid for property in 2000 or so, but he says it would be worth $450,000 with a clear title. Over seven years, Long says, he begged the prosecutor's office to evict squatters. "It was driving me crazy," he recalls. "I had dreams about going over there and shooting all these guys."

Drawn by the warm surf, Texas native Edward Sides, 37, moved to Herradura after college in 1996 and opened a convenience store. Like many of his neighbors, he bought a small piece of land and a house from a squatter on rights of possession, but he managed in 2000 to track down the titleholder's surviving sister in Vista, California and paid perhaps as little as $5,000. But even as he stayed put on his property, he contended with squatters. Title in hand, he and attorneys repeatedly trudged to the Puntarenas court, spending hundreds of thousands of dollars until a judge finally granted eviction orders in 2007.

That decision was a miracle, Sides says. But he still had to get rid of 50 squatters living in structures that ranged from shacks to vacation homes with swimming pools. Sides bussed in and fed 350 police. Not enough. He hired a private security detail of 70, built a metal barricade around the property and put up a half-dozen guard towers. He rented bulldozers to knock down the homes. When protesters rushed, throwing rocks and molotov cocktails, the guards who did not flee in horror fired into the mob. More than a dozen people were injured.

Cloistered behind barricaded walls with a few guards, Sides is still haunted by the specter of violence -- and maintaining the integrity of the paperwork: "I am nervous all the time about my property -- and who is going to try to scam it." He intends to put the land on the market as soon as prices firm, he says. The property might fetch $2.5 million -- from a courageous buyer.

IRS FURTHER DISCOURAGES OFFSHORE BANKS FROM SERVICING U.S. CLIENTS

Offshore banks may be forced to choose between obedience to their home country laws or to the IRS.

The Sovereign Society's Bob Bauman comments in his blog about the IRS's new rules about what it takes for a foreign bank to meet the criteria as a "qualified intermediary."

The IRS, naturally, would like to know about all offshore financial accounts owned or controlled by a U.S. person, natural or artificial (corporations et al). Fairly tight requirements already exist for U.S. persons reporting such accounts, but the IRS also demands information from offshore financial institutions to provide them with a crosscheck that everyone who should be reporting is doing so. Those institutions that meet those demands are deemed qualified intermediaries. Those that do not, yet accept U.S. clients, can be denied access to the U.S. banking system. Thanks to the U.S. dollar's continued dominance in the world financial system, this would effectively ostracize the offending institution from the world financial community at large, and effectively put it out of business.

A look through the latest revisions to the IRS QI rules shows them to be similar in intent to IRS and other U.S. financial police agency rules about "knowing your customer" or reporting "suspicious activity." QIs should have a big compliance departments, etc., etc., yada yada. As Bauman notes, how intrusive these rules are in practice remains to be determined. We are inclined to agree with him that the IRS ultimately will press the rules to the point where countries will have to compromise on their privacy/secrecy laws in order to stay connected to the U.S. financial system. At long last the gloves will come off entirely. At that point we suspect most will just choose to stop servicing U.S. clients entirely.

As I predicted months ago, the U.S. Internal Revenue Service wants to clamp down with greater long-distance oversight of foreign banks that provide banks accounts or sell offshore services to American clients. The goal? Thwarting what IRS agents claim -- without offering any proof -- to be rampant tax evasion.

New IRS rules, issued [October 13], toughen up the little known, IRS "qualified intermediary" (QI) program that currently allow participating foreign banks to maintain accounts on behalf of American clients without disclosing their names to the IRS. Until now the IRS has allowed the banks to promise to identify clients, withhold any taxes due on U.S. securities in their accounts, typically 30%, and send the tax money owed to the IRS.

Under the newly proposed IRS rules, foreign banks in the QI program must now actively investigate, determine and report to the IRS whether United States investors or their legal entities are the holders of the foreign accounts they open. (U.S. persons already are required by law to report offshore accounts on the annual IRS Form 1040).

... When the account value exceeds $10,000 at any point during the year, we assume he meant to add. Moreover, if the total value of all offshore accounts is in excess of $10,000 at any point during the year then all offshore accounts must be reported. These reporting requirements apply to legal entities such as trusts and corporations as well as citizens, resident aliens, etc.

No Americans Wanted

In the last year numerous offshore banks, wary of increasing IRS pressures, have begun refusing to accept any new American clients. These latest IRS rules will only increase this unfortunate anti-American trend. (Ask us: we know where the still American-friendly offshore banks are).

The new rules, to take effect in 2010, will also require foreign banks to alert the IRS to any potential fraud, whether detected through their own internal controls, complaints from employees or investigations by regulators. The IRS will also begin auditing small samples of individual bank accounts in the program, without knowing the clients' names, to determine whether American investors actually have control over foreign entities with bank accounts.

Qualified Intermediary (QI) Rule

More than 7,000 foreign banks participate in the program, which was established in 2001, to help the IRS keep track of American offshore investors. Under current rules, foreign banks need only report to the IRS U.S. clients' investments in American securities.

According to the IRS, foreign banks in the QI program hold more than $35 billion abroad in accounts for U.S. individual investors, partnerships, trusts, family foundations and corporations, but withheld taxes of only 5% on that amount in 2003. The IRS argues entities receiving the offshore income claimed exemptions under foreign double taxation treaties with the United States, but if U.S. investors controlled those entities, some were not entitled to the tax exemptions.

Note that $35 billion is a tiny drop in the ocean relative to all U.S. financial assets, cross-border funds flows, or any other metric you care to choose. So the IRS focus here is not rational on the face of it, but undoubtedly quite rational from a broader perspective, e.g., when the possibility of future capital controls is considered.

The clear threat to offshore banks underpinning the QI rules is the possibility that an uncooperative foreign bank would be denied access to the entire American banking system, meaning they and their clients could not to do business with the major banking system of the world.

Alleged Tax Evading Bank Gets $54 Billion U.S. Loan

The tightened QI rules are said to be the result of allegations that the world's largest private bank, the Swiss UBS, assisted an unknown number of their American account holders to evade U.S. taxes.

(To show just how schizophrenic is U.S. government policy, the Swiss government announced [on October 16] that the U.S. Federal Reserve has joined with the Swiss National Bank to loan up to $54 billion from the Fed to buy "illiquid securities" from subprime-loaded UBS!)

The IRS claims that since 2001 it has halted the participation in the QI program by about 100 foreign banks that were accused of violating QI rules. But in my observation, far fewer banks were embargoed and those tended to be banks located in backwater places such as Vanuatu and the Solomon Islands where Russian criminal elements had established a financial presence.

U.S. Rule Imposed Worldwide

In 2001 the IRS first imposed extraterritorial tax enforcement burdens on foreign banks that were forced to meet IRS established anti-money laundering and "know your customer" standards in order to get the "QI" stamp of approval.

But IRS QI approval comes loaded with onerous conditions that now might end customer confidentiality for American offshore investors. It also gives the IRS leverage over foreign nations when demanding exchange of tax and financial information. Some nations, such as Switzerland, Liechtenstein and Panama that have strict financial privacy laws, until now have been able to escape the worst anti-privacy parts of the QI rules.

Tougher New QI Rules

Douglas H. Shulman, the IRS Commissioner, said the goal of the new QI changes "is to get a clear line of sight into the owners of the bank account, and to know where there is fraud." Inherent in such an overreaching statement is the misguided IRS belief that everyone with an offshore bank account is engaged in tax evasion -- and that offshore banks have a duty to act as IRS informers.

I will repeat what I have said before: It is the duty of the American government to investigate and indict anyone suspected of violating laws -- on an individual case basis. It is not the government's duty or right to coerce offshore bankers to act as IRS agents, or to presume tens of thousands of Americans legally engaged in offshore financial activity are therefore criminals.

Conflict of Laws

It remains to be seen how any new QI rules can be made to square with strict laws guaranteeing financial and banking secrecy in many nations, such as Switzerland, Liechtenstein, Andorra, Monaco, Singapore, Belize or Panama. Typically those laws make it a criminal act to reveal any information about bank account holders, foreign or domestic, unless order to do so by a court.

Offshore banks may be forced to choose between obedience to their home country laws, or to the grasping long arm laws of the IRS.

PERSONAL INCOME TAXES FALL AS GOVERNMENTS COMPETE FOR TALENT

Top personal income tax rates around the world have fallen by an average of 2.5% over the past six years in the face of increasing global labor mobility.

"Tax competition" has led to incremental reductions in top tax rates, which apply to those earning the most income, in many countries around the world. It is very reasonable to guess that this is due to governments' understanding that this is an effective active step towards attracting the high earners.

KPMG has documented the reduction in tax rates, and cites a variety of anecdotal evidence that supports the idea of overt recognition by governments that lowering taxes might attract desirables, such as the competition between Hong Kong and Singapore, and the incidental effects this has had on Australia. Economic theory would predict that this would happen once labor became a sufficiently mobile factor. Ultimately the best protection against predatory government is the capacity to move the target, whether that be your wealth or your body, at reasonably low cost.

Top personal income tax rates around the world have fallen by an average of 2.5% in the past six years, as governments strive to balance their need for revenue with the impact of increasing global labor mobility, a new study from KPMG International has found.

Worldwide, top personal tax rates have fallen from an average of 31.3% in 2003 to 28.8% in 2008. But European Union (EU) taxpayers still pay the highest rates, at an average of 36.4%, followed by taxpayers in the Asia Pacific countries with an average of 34.6% and those of Latin America at 26.9%, KPMG said.

At a country level, the highest tax rates in the world are paid by the people of Denmark, with a top rate of 59% for the whole six years, followed by those of Sweden, whose rate came down last year from 57% to 55%, and those of the Netherlands, who have paid 52% for the whole period.

Excluding those countries which levy no tax at all, the lowest EU rate is in Bulgaria, with a newly introduced flat rate of 10%, down from 24%. In Asia Pacific the lowest is in Hong Kong, with 16% and in Latin America it is in Paraguay with 10%. Of the 87 countries surveyed, 33 have cut their rates in the past six years and only seven have a higher top rate in 2008 than they did in 2003.

Among the large western European economies, France has made the most significant cut in its rates, from 48.1% in 2003 to 40% in 2007. Germany has gone from 48.5% to 45%, having briefly stood at 42% in 2005 and 2006.

But across the EU it has been the introduction of flat rate taxes in the Eastern European states that has had the most impact, KPMG said. As well as Bulgaria's new flat rate of 10%, Estonia has cut its rates from 26% in 2003 to a flat 21% in 2008; Slovakia has gone from 38% to a flat 19%; Lithuania last year fell 6 points to 27% and this year a further 3 points to a flat 24%; Romania has cut rates from 40% to a flat 16%; and the Czech Republic, this year, introduced a flat rate tax set at 15%.

In the Asia Pacific region, tax competition between Hong Kong and Singapore has led Singapore to cut its rate from 22% for 2003 to 21% in 2006 and 20% in 2007. However, both the Hong Kong and Singapore governments offer their citizens tax rebates when public finances allow. For 2007/08, these rebates were 20% in Singapore, capped at SGD2,000 (US$1,400) and 75% in Hong Kong, capped at HKD25,000 (US$3,200).

"Australia also cut its personal tax rate by two points to 45% last year," said Rosheen Garnon, head of KPMG's International Executive Services practice and a partner in the Australian firm, "but if the intention was to attract back high value Australian workers who have temporarily moved to Hong Kong or Singapore, it may not be enough."

"It is common to hear from foreign workers that once families have become accustomed to the huge increase in spending and saving power that low tax rates provide, it can be very difficult to justify going home," Garnon added.

In Latin America, personal tax rates have generally stayed low but stable. There is an increase in the average, from 25.6% in 2003 to 26.9% in 2008, but this is entirely due to the introduction of a 10% income tax in Paraguay and a 25% tax in Uruguay, both effective from 2007.

Elsewhere in the region, tax movements have all been down, the survey found. Mexico and Panama stand out for their steady, year-on-year reductions. In the past six years, Panama has gone in stages from 33% to 22%, while Mexico has gone from 34% to 28%.

"Given that the share of national wealth taken by tax revenue in many countries is static, or has increased in the past five years, the fall in personal and corporate tax rates raises the question of how governments are now raising funds," observed Garnon. "We think the answer may lie in increases in indirect taxation, through value added taxes, goods and services taxes, customs duties and fees for specific services."

"We do not foresee a time when personal income taxes will fall so far that they become irrelevant to people moving from country to country. But it is entirely possible that the relative level of indirect taxes will begin to play a much greater part in people's decisions on where in the world to go for work," Garnon concluded.

IRS HOLDING $266 MILLION IN UNDELIVERABLE REFUNDS

How can people stimulate the economy without their refunds?

A small percentage of U.S. taxpayers have a different kind of issue with the IRS: The IRS is trying to reach them in order to give them money. Who says the IRS does not have a heart?

The IRS is looking for taxpayers who are missing more than 279,000 economic stimulus checks totaling about $163 million and more than 104,000 regular refund checks totaling about $103 million that were returned by the U.S. Postal Service due to mailing address errors.

"People across the country are missing tax refunds and stimulus checks. We want to get this money into the hands of taxpayers where it belongs," said IRS Commissioner Doug Shulman. "We are committed to making the process as easy as possible for taxpayers to update their addresses with the IRS and get their checks."

Taxpayers who may be due a stimulus check must update their addresses with the IRS by November 28, 2008. By law, economic stimulus checks must be sent out by December 31 of this year. The undeliverable economic stimulus checks average $583. The regular refund checks that were returned to the IRS average $988. The agency said that these checks are resent as soon as taxpayers update their address.

According to the IRS, the vast majority of checks mailed out reach their rightful owner every year. The agency added that only a very small percentage are returned by the U.S.P.S. as undeliverable.

Through September 2008, the government distributed 116 million economic stimulus payments with only about 279,000 checks being undeliverable. Meanwhile, the IRS has distributed more than 105 million regular refunds this year with only about 104,000 being undeliverable. In both cases, well under 1% of refunds or stimulus checks were undeliverable.

However, the agency is keen to point out that if taxpayers choose to have their refunds directly deposited in their bank accounts, then the possibility of payments getting lost in the post is eliminated.

And then if the IRS ever needs to conduct a transaction where the funds flow the opposite way, well, how convenient if this arrangement should be in place.

GUERNSEY SET TO INTRODUCE DEPOSIT GUARANTEE SCHEME

Offshore havens are scrambling to preserve their reputations in the face of losses sustained by depositors of haven branches of failed banks. A bit late in the day, havens are discovering they are getting caught in the blowback of failures in their jurisdictions even when no promises of any sort were made and the failed institution's headquarters were clearly elsewhere.

In a complex world where depositors and other financial institution liability holders have limited time and access to information, it makes sense to us that offshore havens could regulate -- or at the very least provide an opinion letter of sorts -- on the insitutions that operate within their borders. The act of providing insurance to retail depositors could lead to healthy competition among havens. In fact, it seems like a natural to us in an increasingly crowded field where privacy and other former competition points are being eroded across the board.

Guernsey has announced plans to introduce a non-retroactive deposit insurance scheme following the failure of Iceland bank Landsbanki Guernsey, matching the protection offered by the British government.

Guernsey has taken the next step towards introducing a Depositors' Compensation Scheme with a compensation ceiling of £50,000, Guernsey Finance has announced.

On [October 23], the technical group working on the introduction of a scheme met for the second time. This meeting was to consider an analysis of the deposit base of all banks in Guernsey, which is essential in assessing the potential costs of any scheme. The group is chaired by Treasury and Resources Minister Charles Parkinson and includes representatives of the Commerce and Employment Department, the Guernsey Financial Services Commission (GFSC) and the Association of Guernsey Banks (AGB).

Deputy Parkinson said: "I believe that we have made significant progress towards introducing a Depositors' Compensation Scheme with a compensation ceiling of £50,000, as is currently the case in the UK. ... We are considering schemes already in use in other small jurisdictions and also introducing some of our own thinking."

It has been agreed that the proposed scheme should:

• cover retail depositors, not companies and corporate deposits;
• cover Guernsey residents and non-residents;
• and that compensation would be due in r

Those with deposits in Landsbanki Guernsey are not covered by the Depositor Compensation Scheme nor covered under the UK compensations scheme, since administrators took over on October 7 and any Guernsey scheme would not be retrospective. However, the administrator has announced an interim payment of 30 pence on the pound and made clear that the prospects for further repayments are good.

Charles Parkinson has stressed that Landsbanki Guernsey's assets exceed its liabilities and therefore while he cannot say for certain that depositors will get all of their money back this remains a strong possibility.

The Minister has expressed sympathy with the concern of depositors and highlighted that the States of Guernsey is doing everything it can both locally and internationally, including working at a high level with the UK Government, to ensure that the interests of Landsbanki depositors are represented in meetings with the Icelandic authorities.

The Guernsey Financial Services Commission has also written to the controllers of Landsbanki Guernsey's parent bank -- the Icelandic regulators -- pressing for the bank to honor its commitments to meet the Guernsey bank’s liabilities, including depositor liabilities.

Peter Niven, Chief Executive of Guernsey Finance, said: "It is too early to tell what lasting effects this issue will have on Guernsey's reputation -- that is something which we are watching very closely. What we can say is that Guernsey has come in for criticism from some quarters but its reputation is far from in tatters and this is particularly evident when you place everything in context.

"Together these banks hold £128 billion worth of deposits. The maximum amount in the retail sector (clearing and deposit taking banks) -- and which would be covered by a Depositors' Compensation Scheme -- is approximately 14% of the total, £17.8 billion, with approximately £4 billion of this in the deposit taking banks. Therefore the bulk of deposits in Guernsey banks, 86% of the total, are wholesale deposits in the 'other banks.' They would not be covered by a Depositors' Compensation Scheme. ...

"What this demonstrates is that the vast majority of deposits in Guernsey banks are effectively 'non-retail' and are made up of inter-bank deposits, corporate deposits and deposits associated with other aspects of the finance industry. Despite the size of this sector however the collapse of a retail deposit taker is likely to have a much more significant effect on individual depositors and Guernsey's international reputation among this sector of the Island's client base."

Jersey Weathering Financial Storm

While Guernsey is dealing with the aftermath of a Iceland bank subsidiary's failure, Jersey regulators, either prudently or by luck, never licensed any Icelandic banks to do business within their purview. Jersey has announced a deposit guarantee scheme similar to those of Guernsey and the UK, while saying it is doubtful that it will ever have to be used.

When history is written about the ongoing and spectacular popping of the worldwide credit bubble, those institutions and jurisdictions which protected their clients by having avoided the minefields which were laid during the preceding boom will get their rightful due. As the worst is probably yet to come, who those will turn out to be is uncertain. As for Jersey: So far, so good.

Jersey Finance, the jurisdiction's investment promotion body, has assured financial businesses in Jersey and elsewhere that despite the global economic turmoil the Island is in a stronger position than many other international financial centers.

According to a statement, released after an online question and answer session with the media last week, Jersey's banks have experienced "very low exposure" to risk assets such as the toxic debt which has created liquidity issues for some banks around the world.

Jersey is expected to weather the banking storm relatively unscathed because most of its banks are branches and subsidiaries of those banks that are being supported by governments in the UK, U.S., EU and elsewhere. Jersey's banks currently perform above the minimum requirements for the risk asset ratio (RAR) of 8% laid down by the Basel banking convention, and many banks are averaging 50% above this level.

"Jersey is part of the solution for many of these parent banks because their Jersey operations are effectively providers of much needed liquidity (from cash deposits)," the statement explained. "Jersey is in a strong position as a provider of very significant and important liquidity to banking groups which is fundamental to their continuing commercial operations. Jersey's strong system of regulation, the long-standing nature of business in the Island and the deep pool of financial services talent the Island can draw upon further reinforce this strong position."

Jersey Finance also confirmed that Jersey had no interests in Icelandic Banks and no Icelandic banks were licensed to do business in Jersey.

Despite the lack of confidence in the banking sector globally, the report says Jersey has still retained "significant inflows of funds." No comments were made into the extent of withdrawals but Jersey Finance insists "the finance industry has continued to operate as usual."

The statement added that all Jersey residents' deposits will be guaranteed in the unlikely event that a bank based in Jersey were to fail, the full amount would be guaranteed from October 10, 2008. The guarantee is subject to final approval of the States following any bank failure.

IN PRAISE OF BANKRUPTCY

The present financial problems would disappear quickly if the government let the markets operate and let inefficient firms go bankrupt.

Usually when the subject of bankruptcy is brought up on this site it is in the context of keeping misfortune in one area of one's financial affairs from spilling over into others due to ill-conceived and irrational laws. Here, economics professor Henry Thompson praises bankruptcy as a natural process in the business ecosystem, and explains how and why the government is trying to thwart the workings of the process.

Bankruptcy involves the nonperformance of a financial contract. If the cleanup process is not interfered with, the assets involved get recycled and redeployed quickly, just as happens following a death in the natural world.

When the business involved is big and includes a concentration of political interests, the process of bankruptcy will be interfered with. Resources such as labor get stuck in nonproductive uses. Capital assets that should be allowed to decay are instead uneconomically sustained. Alternative redeployments that would result in far greater contributions to the welfare never see birth.

In one word, the market approach to the financial problem is bankruptcy. Firms go bankrupt when they do not have enough revenue to pay their bills. Banks make money by borrowing from lenders at a low interest rate and lending to borrowers at a higher interest rate. If banks make bad loans and borrowers quit repaying, banks go bankrupt.

Insurance firms help people avoid risk, collecting premiums to pay those who suffer bad luck. If the premiums collected by an insurance firm are less than what it has to pay, it goes bankrupt. AIG sold insurance policies to stockholders that banks and other firms would not go bankrupt and could not pay the policies when that happened.

Bankruptcy is a normal part of economic life, covered by laws that guarantee stockholders will be compensated as much as possible. More efficient firms move in to take over what is left of bankrupt firms, buying what can be put to productive use. There is no crime in bankruptcy and, if handled quickly, little economic harm. When the largest U.S. energy company Enron went bankrupt a few years ago, there was not even a ripple in the energy markets, much less the economy. Bankruptcy is not criminal and should not be a surprise, but it can be unnerving if large, well-known firms go bankrupt.

Banks and insurance firms are careful when lending or selling policies because they want to ensure their revenue will pay their bills. Government involvement, however, provides a cushion for failure and allows banks and insurance firms to be careless. This carelessness occurred with the government-sponsored mortgage bank, the Federal National Mortgage Association.

Fannie Mae provides backing to mortgage banks, more or less encouraging them to make bad loans. Fannie Mae makes subsidized loans to mortgage companies when they are short of cash. Freddie Mac is a government mortgage bank that sells mortgages without the usual worry of making a profit, given its taxpayer backing. The government has taken over these two losing mortgage banks, and losses will be paid by taxpayers.

The government provides subsidized mortgage insurance in case home buyers cannot pay. This insurance lets commercial mortgage banks relax and make loans to people who might not be able to pay. Government support for people wanting to buy a house elevated demand for houses and pushed up prices. Rising prices made home buyers confident they could buy a house they could not afford and sell it soon for a profit, counting on a "greater fool" to come along. Realistically, people should only buy a house when they plan to live in it and can actually pay for it. Greater fools do not always come along.

The result of government meddling in the mortgage market is that people have bought houses they cannot afford. When prices quit going up, people were left owing more on their house than it was worth in the market. With their subsidized mortgage insurance and little penalty, people defaulted on their mortgages. The mortgage banks are left without income. This mortgage mess is the root cause of the present financial crisis.

One part of the evolving financial bailout is the government using taxpayer money to help people who have not been able to pay their mortgage. The government is taxing those who have paid their mortgages and transferring the money to those who have not. It is not a good idea to reward inefficiency.

The government is also giving money to select financial and insurance firms, rewarding their poor performance with taxpayer money. Better advice is, "Don't throw good money after bad." The failed firms should go bankrupt. ...

The underlying goal of the financial bailout is not to keep the economy "healthy" but to keep a few Wall Street firms, mortgage banks, and insurance firms in business. Never mind that most mortgage and insurance firms in the country are profitable. The government wants to support the inefficient, large, high-profile firms. If these firms were allowed to go bankrupt, the economy would recover quickly. Other firms, not necessarily with an address on Wall Street, would step in and buy them out. Wall Street is much less important now than in the past, due to national and global financial competition.

Profit motives in business are clear, but governments have no profit motive and are able to collect taxes, print money, and borrow against future taxpayer money to pay their bills. Mortgage and other financial-market firms will wait to see what the government agencies do in the market and then generally do the opposite, playing against taxpayer money. The rules are changing with more government involvement, but competition will continue. The situation would be like the government making delivery of packages less than 5 pounds illegal except by the US Post Office.

The present financial problems would disappear quickly if the government let the markets operate and let inefficient firms go bankrupt. The irony is that the government is stepping in to solve the problems it created. The solution might "work," but the underlying disincentives in the mortgage and insurance markets will persist. Increased government meddling in the financial markets will only make the financial problems linger.

MOST PRESIDENTS IGNORE THE CONSTITUTION

The de facto Constitution they swear to: Whatever they think they can get away with.

Judge Andrew P. Napolitano's book A Nation of Sheep "discusses how the federal government has circumvented the Constitution and is systematically dismantling the rights and freedoms that are the foundation of American democracy." Does he expect either of the two major presidential candidates to uphold the oath he will take to uphold the U.S. Constitution? Um, no.

"Do the people we send to the federal government recognize any limits today on Congress's power to legislate?", Napolitano asks. "The answer is: Yes, their own perception of whatever they can get away with."

In a radio interview in 2001, then-Illinois State Sen. Barack Obama noted -- somewhat ruefully -- that the same Supreme Court that ordered political and educational equality in the 1960s and 1970s did not bring about economic equality as well. Although Mr. Obama said he could come up with arguments for the constitutionality of such action, the plain meaning of the Constitution quite obviously prohibits it.

Mr. Obama is hardly alone in his expansive view of legitimate government. During the past month, Sen. John McCain (who, like Sen. Obama, voted in favor of the $700 billion bank bailout) has been advocating that $300 billion be spent to pay the monthly mortgage payments of those in danger of foreclosure. The federal government is legally powerless to do that, as well.

When Franklin Delano Roosevelt first proposed legislation that authorized the secretary of agriculture to engage in Soviet-style central planning -- a program so rigid that it regulated how much wheat a homeowner could grow for his own family's consumption -- he rejected arguments of unconstitutionality. He proclaimed that the Constitution was "quaint" and written in the "horse and buggy era," and predicted the public and the courts would agree with him.

Remember that FDR had taken -- and either Mr. Obama or Mr. McCain will soon take -- the oath to uphold that old-fashioned document, the one from which all presidential powers come.

Unfortunately, these presidential attitudes about the Constitution are par for the course. Beginning with John Adams, and proceeding to Abraham Lincoln, Woodrow Wilson and George W. Bush, Congress has enacted and the president has signed laws that criminalized political speech, suspended habeas corpus, compelled support for war, forbade freedom of contract, allowed the government to spy on Americans without a search warrant, and used taxpayer dollars to shore up failing private banks.

All of this legislation -- merely tips of an unconstitutional Big Government iceberg -- is so obviously in conflict with the plain words of the Constitution that one wonders how Congress gets away with it.

In virtually every generation and during virtually every presidency (Jefferson, Jackson and Cleveland are exceptions that come to mind) the popular branches of government have expanded their power. The air you breathe, the water you drink, the size of your toilet tank, the water pressure in your shower, the words you can speak under oath and in private, how your physician treats your illness, what your children study in grade school, how fast you can drive your car, and what you can drink before you drive it are all regulated by federal law. Congress has enacted over 4,000 federal crimes and written or authorized over one million pages of laws and regulations. Worse, we are expected by law to understand all of it.

The truth is that the Constitution grants Congress 17 specific (or "delegated") powers. And it commands in the Ninth and 10th Amendments that the powers not articulated and thus not delegated by the Constitution to Congress be reserved to the states and the people.

What is more, Congress can only use its delegated powers to legislate for the general welfare, meaning it cannot spend tax dollars on individuals or selected entities, but only for all of us. That is, it must spend in such a manner -- a post office, a military installation, a courthouse, for example -- that directly enhances everyone's welfare within the 17 delegated areas of congressional authority.

And Congress cannot deny the equal protection of the laws. Thus, it must treat similarly situated persons or entities in a similar manner. It cannot write laws that favor its political friends and burden its political enemies.

There is no power in the Constitution for the federal government to enter the marketplace since, when it does, it will favor itself over its competition. The Contracts Clause (the states cannot interfere with private contracts, like mortgages), the Takings Clause (no government can take away property, like real estate or shares of stock, without paying a fair market value for it and putting it to a public use), and the Due Process Clause (no government can take away a right or obligation, like collecting or paying a debt, or enforcing a contract, without a fair trial) together mandate a free market, regulated only to keep it fair and competitive.

It is clear that the Framers wrote a Constitution as a result of which contracts would be enforced, risk would be real, choices would be free and have consequences, and private property would be sacrosanct.

The $700 billion bailout of large banks that Congress recently enacted runs afoul of virtually all these constitutional principles. It directly benefits a few, not everyone. We already know that the favored banks that received cash from taxpayers have used it to retire their own debt. It is private welfare. It violates the principle of equal protection: Why help Bank of America and not Lehman Brothers? It permits federal ownership of assets or debt that puts the government at odds with others in the free market. It permits the government to tilt the playing field to favor its patrons (like J.P. Morgan Chase, in which it has invested taxpayer dollars) and to disfavor those who compete with its patrons (like the perfectly lawful hedge funds which will not have the taxpayers relieve their debts).

Perhaps the only public agreement that Jefferson and Hamilton had about the Constitution was that the federal Treasury would be raided and the free market would expire if the Treasury became a public trough. If it does, the voters will send to Congress those whom they expect will fleece the Treasury for them. That is why the Founders wrote such strict legislating and spending limitations into the Constitution.

Everyone in government takes an oath to uphold the Constitution. But few do so. Do the people we send to the federal government recognize any limits today on Congress's power to legislate? The answer is: Yes, their own perception of whatever they can get away with.

DEFLATIONARY PULLBACK PRECEDES HYPERINFLATIONARY TSUNAMI

Many people, even a few mainstream analysts, have wondered whether a "killer wave" of inflation will be arriving once the current deflation works its way through the system. But no one has worked the metaphor so well as James Howard Kunstler does here, connecting the current stage to when the water recedes and exposes "historic wrecks" and "exotic creatures." Everyone stands around and gawks at the strange event, unaware of the carnage that will be visited when the water returns, which Kunster believes will take the form of hyperinflation.

It is fascinating to read the commentators in mainstream journals like The Financial Times and The Wall Street Journal all strenuously pretending that "the worst is over" (maybe ... we hope ... fingers crossed ... hail Mary full of grace ... et cetera). The cluelessness would be funny if it did not involve a world-changing catastrophe. All nations that have reached the fork-and-spoon level of civilization are now engineering a vast network of cyber-cables that lead directly from their central bank computers to the Death Star that is hovering above world financial affairs like a giant cosmic vacuum cleaner, sucking up dollars, euros, zlotys, forints, krona, what-have-you. As fast as the keystrokes create currency-pixels, the little electron-denominated units of exchange are sucked out of the terrestrial economies into the black hole of money death. That is what the $700-billion bailout (excuse me, "rescue plan") and all its associated ventures are about.

To switch metaphors, let us say that we are witnessing the two stages of a tsunami. The current disappearance of wealth in the form of debts repudiated, bets welshed on, contracts canceled, and Lehman Brothers-style sob stories played out is like the withdrawal of the sea. The poor curious little monkey-humans stand on the beach transfixed by the strangeness of the event as the water recedes and the sea floor is exposed and all kinds of exotic creatures are seen thrashing in the mud, while the skeletons of historic wrecks are exposed to view, and a great stench of organic decay wafts toward the strand.

Then comes the second stage, the tidal wave itself -- which in this case will be horrific monetary inflation -- roaring back over the mud flats toward the land mass, crashing over the beach, and ripping apart all the hotels and houses and infrastructure there while it drowns the poor curious monkey-humans who were too enthralled by the weird spectacle to make for higher ground. The killer tidal wave washes away all the things they have labored to build for decades, all their poignant little effects and chattels, and the survivors are left keening amidst the wreckage as the sea once again returns to normal in its eternal cradle.

So, that is what I think we will get: An interval of deflationary depression followed by a destructive wave of inflation that will wipe out both constructed debt and constructed savings, scraping the financial landscape clean. There is no question that stage one is underway. But we can be sure the giant wave of money recklessly loaned into existence in just a few weeks time will wash back through the global economy leaving a swath of destruction.

And then what? The societies of the world will be faced with the task of rebuilding systems of fruitful activity, i.e., real economies based on productive behavior rather than the smoke-and-mirrors of Frankenstein-finance con games. In fact, excuse me while I switch metaphors again, because the Frankenstein story -- the New Prometheus -- is yet another apt narrative to inform us what we have done.

We have "played" with financial fire and brought to life a monster now bent on killing us. One question that this metaphor-narrative raises is when will the angry peasant mob storm the castle with their flaming brands and cries for blood from the makers of this monster? Rather soon, I think. Perhaps, in some countries (maybe the USA, if we are lucky), this will take the more orderly form of systematic prosecutions, bringing to justice persons who perpetrated swindles involving the alphabet soup of investment "products" that have gone bad in so many accounts (and ruined so many individuals, institutions, and governments). I think it has already begun with the inquisitors summoning the shifty Dick Fuld of Lehman Brothers -- but there are hundreds of other characters like him out there, who scored untold millions of dollars in activities that were simply grand swindles. I would not be surprised if, eventually, Treasury Secretary Hank Paulson found himself in the dock to answer how come, when he ran Goldman Sachs, there was a special unit in the company dedicated to short-selling the very mortgage-backed securities that another unit in the company was so busy pawning off to every pension fund on God's green earth.

Apart from orderly prosecutions (which can certainly turn harsh and cruel), there is the possibility of sociopolitical upheaval -- revolution, violence, civil war, war between nations, the whole menu of monkey-human mischief that afflicts mankind. We are not necessarily immune to it here in the USA, despite our cherished notion of exceptionalism, which would have us inoculated against all the common vicissitudes of history.

Anyway, prosecution through the courts, while perhaps satisfying the hunger for justice (or, more particularly, revenge), is not a productive economic activity. So, the question begs itself again: What will we do? Under the best circumstances we will reorganize our society and economy at a lower level of energy use (and probably a lower scale of governance, too). The catch is, it will have to be a whole lot lower. I think we will be very lucky 50 years from now to have a few hours a day of electricity to do things with.

The energy story and its handmaiden, the climate change situation, are both lurking out there beyond the immediate spectacle of the financial fiasco. Both these things imply pretty strongly that the economic relations currently unraveling will not be rebuilt -- not the way they were before, or even close to it. The best outcome will be societies that can practice small-scale "process-intensive" organic agriculture and equally small-scale process-intensive modes of manufacture in the context of very local sociopolitical networks. An accompanying hope is that we can remain civilized in the process. Personally, while I recognize the appeal (to others, not me) of the "singularity" narrative, which has the human race making a sudden evolutionary leap into some kind of cyborg-nirvana, I regard it as an utter bullshit fantasy that has zero chance of occurring, given our stark predicament.

But returning to the short term, or "the present," shall we say, there is the matter of how the U.S. gets through the election and then the first months of a new government, even while the larger fiasco continues. I am voting for Mr. Obama. While I believe he will make a much better president than the addled old mad dog Mr. McCain has become, I feel sorry for anyone who is placed nominally "in charge" of things this coming year. The best a President Obama can do is offer some reassurance to a public that is totally unprepared for the convulsion now upon us.

Mr. Obama will certainly not have "money" to "spend" on any of the promised social support programs that have been endlessly debated. But he could clearly articulate the reality we are facing, and ask not necessarily for "sacrifice," as the common plea goes, but for something more and better: for bravery and resolute spirit, for intelligence and resilience, for kindness and generosity -- among a people long unused to consorting with the better angels of their nature. He has already begun to set the example by appearing in public with his sleeves rolled up. The change that has been in the air all year -- that Mr. Obama has talked so much about -- is coming in a bigger dose than anyone expected. I hope we are ready to get with the program.

“THE CRASH MUST COME”

Intervention cannot stop the business cycle.

Barron's editorial page editor Thomas Donlan considers the quotes coming from the likes of European chiefs of state and others who are reveling in the "failure of capitalism," such as the New York Times and Washington Post, and wonders just what they have in mind as a replacement. French president Sarkozy admits, in a brief moment of clarity, that "what happened was a treason of the values of capitalism. The market economy itself is not called into question." Hopefully some of that thinking makes its way into whatever "reforms" the head statists have in mind, as opposed to yet another world-improvement-scheme-lite which tries to mould humans in the image of the gods on earth.

The bailout economy has a very exciting meaning for some: It signals the death of American capitalism. As a "news analysis" in the Washington Post a couple of weeks ago claimed: "The worst financial crisis since the Great Depression is claiming another casualty: American-style capitalism."

The French president, Nicolas Sarkozy, has announced, with neither a trace of an accent nor a trace of sarcasm, that "Laissez-faire is finished."

"The U.S. will lose its status as the superpower of the world financial system," chortled the German finance minister, Peer Steinbruck. "This world will become multipolar."

Even U.S. Treasury Secretary Hank Paulson, the man seemingly in charge of saving American capitalism, or at least saving leading American capitalist institutions, has had his moments of doubt: "Raw capitalism is a dead end," he told a business magazine.

He said that he had seen the dead end in his world travels to places "where there is just the profit motive." He did not name any, although he did not have to leave his old trading floor at Goldman Sachs to find one.

The End of Human Nature

In one of the more lucid passages of Das Kapital, Karl Marx said, "In every stockjobbing swindle everyone knows that some time or other the crash must come, but every one hopes that it may fall on the head of his neighbor, after he himself has caught the shower of gold and placed it in safety. ‘Après moi le déluge!’ is the watchword of every capitalist and of every capitalist nation."

He had a good point, quite applicable to the current situation. But we ought to realize that Marxists and others who would hail the end of capitalism must be hailing the end of human nature -- just as Marx himself aspired to do.

Capitalism -- investment for profit -- is universal. Neither politics nor revolution can kill it. Markets even existed in the old Soviet Union, even in periods when the penalty for profiteering was death, because, for society to function, goods and services must be exchanged at a mutual profit.

Like the character in Moliere's Bourgeois Gentilhomme who discovers to his amazement that he has been speaking prose all his life, we are all capitalists, even those of us who do not know it.

Markets and the people in them go through cycles of boom and bust, fueled always by alternating phases of cheap and scarce capital. The question is whether people in organized institutions can behave more sensibly than individuals in crowds. History provides few examples to support those who believe that politicians can use government power to regulate and improve individuals' impulses.

Mr. Donlan oddly neglects to add that central banks exacerbate the booms and busts by an order of magnitude. Government power fails miserably to regulate or improve individual impulses, but exagerates them.

That does not stop them from trying to end the business cycle.

Our former colleague James Grant, that most literary of financial writers, ably catalogued these cycles in a 1992 book called Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken. He followed 120 years of inhalations and exhalations of credit, providing fascinating tales of banking ineptitude along the way.

Reviewers said the book should be required reading for bankers, but of course the industry never got the message.

Jim did not suggest that the story would end with the excesses of the Milken era, and we understand that he has a new book coming out called Mr. Market Miscalculates: The Bubble Years and Beyond. Buy it.

Making Better Markets

In a wiser moment, Sarkozy said recently that "what happened was a treason of the values of capitalism. The market economy itself is not called into question."

We hope it is this Sarkozy who attends the world economic summit in Washington after the U.S. election. Perhaps he can lead the world to understand that capitalism is the application of money to practical ends, not a political system for the rich to rule the poor.

Strong stuff coming from a Barron's editor. It must be too obvious to ignore that "trickle down" has given way to "trickle up."

The world does need better financial markets, in which speculators and investors can demand and receive better information about the recipients of their money and their prospects for success. Unfortunately, government regulation and international regulation have proven poor substitutes for skeptical capitalists. Markets (as consitituted) are not safer. They are, in fact, more dangerous because speculators believe themselves protected by omniscient bureaucrats.

Another possibility is that Sarkozy, a true French director, will demand that the Washington meeting produce hot air about a new world financial order, in which chastened American speculators line up to endorse and finance a European-style welfare state with full medical coverage, endless unemployment benefits, perfectly secure investment vehicles and stagnant growth.

Either possibility could be the meaning of Sarkozy's repeated calls for a new Bretton Woods agreement.

A Model Hotel

For a small irony, however, the famous Mt. Washington Hotel in Bretton Woods, New Hampshire, is a model for the right way to deal with the current crisis. New owners risked capital to purchase it cheaply out of bankruptcy in 1991. They reorganized and modernized it. The hotel was secured against White Mountain winters, doubling its business opportunities. It is a showplace again. What the hotel can do, the banks of the world also can do.

A more solemn irony is that the Bretton Woods agreement was no model of multipolarity or world concord. It was dictated by the United States. It reflected the astounding dominance of America in the world economy right after World War II. The U.S. accounted for 40% of global economic output and had at least 80% of the gold reserves. Only the dollar was credible enough to be pegged to gold; other currencies could be pegged to the dollar. Thus, the U.S. became the world's creator and judge of money.

The U.S. eventually abused its power to create the world's money, flooding the globe with unwanted dollars in such profusion that it could not redeem them for gold. In 1971, it admitted that, went off the gold standard and left the world and itself with no restraints on the creation of money and credit.

This is not the Bretton Woods that anyone admits wishing to recreate. But it is the likely result. History can repeat itself, both as tragedy and as farce.

THE WORLD IS NOT FLAT, IT IS FLATTENED

The financial crash exposes the fragility of large swaths of the world. The political consequences will be terrible.

Asia Times's "Spengler" looks at what the world will look like when the U.S. is no longer around to act as world cop and sees something analogous to post-Tito Yugoslavia, or post-Saddam Iraq: "Those who objected to America's role as world policeman will get what they wanted, but they will not like it: A religious war reaching from Lebanon to Pakistan, and Colombian-style narco-war spreading to Mexico and Brazil."

Spengler's conceit appears to be that somehow America could stop all this stuff, if only real men like John McCain stayed in charge ... and if it were not bankrupt. Last we noticed, the expenditure of a trillion dollars and counting plus the exhaustion of the American military has failed utterly to stop a religious civil war in Iraq. As for the narco-wars, the wind-down could start immediately at incalculable savings of money and human suffering if the U.S. would stop its so-called war on drugs. But we do not expect to see such a sensible policy initiative until there is no other alternative, if then.

It was not the world that got flat, contrary to New York Times pundit Thomas Friedman, but the emerging markets that got flattened.

Faddish conventional wisdom over the past few years held that American influence was fading as technology radiated to the far reaches of the world. When America's economy went into a ditch, though, the supposed economic superpowers of the future went flying, like children on skates holding onto the back of truck.

The American consumer, it turns out, played Atlas to the global economy, taking the exports of Asia, so that Asia could buy the commodities of Russia, Latin America and Africa. Remove the American consumer, and Asian exports crash, taking commodity prices along with them.

The financial crash exposes the fragility of large swaths of the world. The political consequences will be terrible. The worst of it is that America will not be around to moderate the melee, not if Democratic Senator Barack Obama is elected president, that is. Those who objected to America's role as world policeman will get what they wanted, but they will not like it: A religious war reaching from Lebanon to Pakistan, and Colombian-style narco-war spreading to Mexico and Brazil.

The wave of American self-pity that may carry Obama to the White House stems, in turn, from a global crisis that has sunk a good deal of the developing world. Worst affected are the most populous Muslim countries, and Russia's "near abroad." Pakistan, Ukraine and Belarus are out of funds and have applied for help to the International Monetary Fund. Indonesia and Turkey face drastically increased borrowing and import costs. Iran's economy will implode with oil in the mid-US$60s.

The table below shows the cost of default protection, a gauge of hard-currency borrowing costs, for some emerging markets. The numbers are somewhat arbitrary, reflecting a freeze on credit to emerging markets.

The table of annual costs of 5-year default protection in basis points above the London interbank offered rate (LIBOR) ranged from 3900 for Argentina, i.e., an interest rate of (LIBOR + 39)%, to 1200 for Russian, to 720 for Egypt and the Philippines.

That is, with LIBOR at 3.5%, the Russian government will pay roughly 15% for dollar funding, while Ukraine and Pakistan will pay about 30%, and Turkey about 11%. That does not accurately gauge the damage to their economies, though, for many of these countries depended on huge borrowings from short-term credit markets that now are frozen.

The economic crisis buoyed Obama out of his post-convention slump and exposed the emptiness of the Republicans. But it also has crushed the aspirations of the most populous Muslim countries. Even before the financial crisis, Pakistan and Turkey had turned towards political Islam. Pakistan's intelligence service is providing support to the Taliban in Afghanistan, jeopardizing the Western position. The financial crisis will push Pakistan further towards radical Islam. Now this proclamation will be preached from every mosque from Tyre to Lahore: "The corrupt West tried to seduce you with consumerism. Now the poisoned gifts of the West are shown to be an illusion, and those of you who lusted after them are left only with your humiliation."

Just what has the rest of the world done to challenge the economic hegemony of the United States? The commodities boom has evaporated in a matter of months, with most raw materials trading at half of their May 2008 peaks. Like the housing bubble in the U.S., the commodities bubble turns out to have been a way for the capital of the West to invent profits where there were none to begin with. With the commodities bubble came a fad for investment in emerging market currencies, drawing hundreds of billions of dollars into high-yielding currencies like the Brazilian real, the Turkish lira and the South African rand. The most popular emerging market currencies have fallen by 30% to 50% from their peaks.

The stock exchanges of the BRIC (Brazil-Russia-India-China) combination have fallen half again as far as the U.S. stock market this year in dollar terms:

No one in Asia, it appears, knows how to make money when American import demand shrinks, and when Asian growth falls, raw materials prices collapse. No one in Latin America, for that matter, seems to know how to make money when raw materials prices collapse. For all the preening and posing of the emerging world's nouveau riche, it turns out that the American consumer was the center of the world economy, and without the American consumer, all that is left are busted stock markets and bad credit.

Most embarrassing for the flat-worlders is the observation that the emerging markets crashed when the world concluded that Washington would not be able to reverse the financial crisis. The economic bomb that detonated in America caused more collateral damage in the emerging markets than casualties at home.

Until July 2008, commodity prices rose as stock prices deteriorated because investors falsely assumed that Washington would set off a new wave of inflation as it rescued the banking system. The commodity producers thumbed their collective nose at economic distress in the industrial world and expected the boom to go on forever. Once the markets concluded that Washington would not be able to prevent a financial collapse, the commodity indices crashed along with stock prices. The commodity producers went from boom to bust almost overnight. (See chart.)

Iran's theocrats, as I reported in June, managed to steal $35 billion from oil revenues. Luxury real estate prices rose to Parisian levels while poor Iranians lacked necessities. With the collapse of the oil price, subsidies for essential items will disappear and the regime will face economic collapse. Before it does so, I believe Iran will undertake an adventure to assert its hegemony in the region, probably at the expense of Iraq.

The low level of violence in Iraq during the past several months owes something to the skill of American arms in the so-called "surge", but it owes even more to a tacit agreement between Iran and the George W. Bush administration: In return for leashing its irregular forces in Iraq, Iran would get a free hand with Hezbollah in Lebanon, and American forbearance with respect to its nuclear weapons program.

The Bush administration's motive to bribe Iran and avoid political damage in Iraq disappears on U.S. presidential election day on November 4. Whether the U.S. administration (or for that matter Israel) has the nerve to launch an air strike on Iran's nuclear facilities is anyone's guess (and everyone is guessing that the answer is negative). Nonetheless, Iran has created the strongest Shi'ite presence since the original battles that determined the succession to the Prophet Mohammed. It can watch the Shi'ite cause fade away with the price of oil, or it can attempt to use its capabilities before they are lost for another thousand years. Nothing at all that we know of the Iranians indicates that they would go quietly into another long night of Sunni oppression.

Iran's leaders, in short, find themselves in a position similar to, but more urgent than, the one that Adolf Hitler described to his senior commanders three weeks after the German invasion of Poland. I have quoted this before, but it deserves to be tattooed onto the foreheads of analysts who think that economic weakness reduces the likelihood of armed conflict.

We have nothing to lose, but much indeed to gain. As a result of the constraints forced upon us, our economic position is such that we cannot hold out for more than a few years. Goering can confirm this. We have no other choice, we must act ... At no point in the future will Germany have a man with more authority than I. But I could be replaced at any moment by some idiot or criminal ... The morale of the German people is excellent. It can only worsen from here.

Iran's ultimate target will be Saudi Arabia, whose largest oil fields are found inconveniently in Shi'ite-majority areas just across the Persian Gulf from Iran. The Saudis will not sit quietly while Iran gains the upper hand in Iraq. Pakistan and Turkey, Sunni powers with large armies, will be loath to allow Iran to dominate the region, and they also will be all the more dependent on Saudi generosity.

A whole generation of Western analysts looked approving on Turkey's turn to Islamism, as I reported last summer. Now Turkey will be Islamist -- and broke. Turkey paid more than 20% for local currency deposits in order to attract the funds to finance a current account deficit amounting to 7% of gross domestic product. The Islamist government of Prime Minister Recep Tayyip Erdogan now faces the worst of all possible worlds. The Turkish lira has lost a third of its value in the past month, and almost all of the devaluation will turn up in higher domestic prices. Credit availability for Turkish businesses will vanish, and Turkey will enter a profound economic crisis.

A belt of ungovernability now stretches from Lebanon to Pakistan, with incalculable political and military consequences. I believe that a Shi'ite-Sunni version of Europe's 17th-century 30 Years' War will engulf the region.

Latin America presents a different malady: It has the middle class that wasn’t. The raw materials boom turned into a windfall for Brazil and Argentina, and the windfall financed spectacular rates of internal credit growth (31% and 38% respectively during the past year). For the first time, Brazil's auto manufacturers produced for internal demand rather than exports, and Sao Paolo choked in traffic while the helicopters of ethanol billionaires buzzed overhead. Argentina is now effectively broke, and the government of Cristina Kirchner has expropriated the country's private pension plans to obtain cash. Its foreign credit has collapsed completely.

Brazil's central bank still has formidable reserves, but the fragile political compromise that has kept a nominally leftist government in power cannot hold under present circumstances. Brazil's enormous underclass is ruled by drug gangs that are better armed than the police. A Brazilian congressional committee was told in February 2006 that corrupt elements in the Argentine army were selling heavy weapons to the Brazilian drug mobs, including anti-tank missiles.

Mexico in some ways is the most worrying place in the Western hemisphere. A low-level civil war between the drug cartels and the federal government has been fought over the past two years, and the cartels are winning. Senior Mexican officials charged with suppression of the cartels have been moving their families quietly out of the country. The collapse of the oil price and the likely collapse of remittances from Mexicans in the United States threaten the stability of the financial system, and the Mexican peso has lost nearly 40% of its value during the past several weeks. With the collapse of the American construction industry, a major source of employment for illegal Mexican immigrants to the U.S., the economic safety valve has broken, and the cartels have in inexhaustible supply of young men willing to risk their lives for a living.

Apart from Western and Central Asia and Latin America, the part of the world most affected by the economic crisis will be the Russian periphery. Ukraine has already joined Pakistan and Iceland at the mendicants' queue before the International Monetary Fund, and a number of other countries may not be far behind. Euphoria over the prospects of Eastern European economies permitted them to borrow massively on the now-frozen interbank market and eat up the proceeds in imports. Eastern Europe has the highest current account deficits in the world, and the greatest dependency on short-term foreign borrowings. "The risks of a hard landing are highest in Eastern Europe," warns the IMF in its just-released Global Financial stability report.

Although Russia has taken on water in the crisis, its position relative to its former satellites has actually strengthened ... There are no winners, but losing the least is the next best thing to winning. If America turns inward, even an economically damaged Russia will loom larger in the world.

SHORT TAKES

Luxembourg Prime Minister says he is open to discussion on bank secrecy.

Jean-Claude Juncker is open to being classified as a duck as long as you do not call him a duck. Keeping up appearances and all that ...

Luxembourg PM Jean-Claude Juncker said ... that he was open to discussions on banking secrecy but would not tolerate accusations that his country was a center for tax evaders. Juncker, who is also chairman of the Eurogroup, said his country had decided weeks ago not to send representatives to a Paris gathering of countries in the OECD to discuss tax havens.

Luxembourg did not need to attend the meeting called by the French and Germans, he said, adding he would be open to discussing transparency in the financial sector in the future. "I am absolutely open to discussing the virtues of banking secrecy ... but we are not prepared to voluntarily place ourselves on a bench of the accused," Juncker told France 2 television in a lively exchange. ...

Juncker told France 2 that there was no sound basis to draw any link between banking secrecy and tax havens. Luxembourg, one of a number of OECD countries that did not attend the ... meeting, said it did not believe it was a tax haven.

"I have spoken to the French prime minister and the French president. ... They told me that when they talk about tax havens, they are not thinking of Luxembourg," Juncker told his country's parliament earlier in the day.

Grenada to Relaunch Offshore Finance Sector

Six years after the collapse of the First International Bank of Grenada, one of the biggest banking cons ever in the face of stiff competition for the honor, Grenada's prime minister says the country is determined to try their hand at offshore financial services again.

Grenada's prime minister says he is determined to relaunch the island's offshore finance sector six years after a multimillion-dollar fraud scheme. Prime Minister Tillman Thomas says his government is "prepared to take the necessary steps to make sure our compliance matches international standards." Thomas told the Caribbean Financial Action Task Force ... that such an action will allow Grenada "to get involved in the financial sector in a legitimate way."

In 2002, Grenada suspended its financial sector's operations after First International Bank of Grenada collapsed and investors were cheated out of US$170 million.

China Cancels Tax on Stock Accounts

Whether or not the Chinese government's tax reductions on property transaction and now interest income are effective at cushioning the country against financial misfortune, give them credit for some economic sense. They are lowering taxes during a downturn after having raised them during the boom.

The Chinese government is continuing to use the various fiscal tools at its disposal to shore up the domestic markets having announced a new measure exempting interest earned in individual stock accounts from tax.

The Ministry of Finance and the State Administration of Taxation announced in a joint statement on Sunday that the 5% tax on interest earnings from stock balances would be scrapped as of October 9, 2008. The move follows the State Council's announcement earlier this month that the 5% withholding tax on interest earned from individuals' bank deposits would also be removed with effect from October 9.

These changes form part of a raft of recent measures put in place by Beijing aimed at stabilizing the Chinese economy and encouraging growth. These include reductions in tax on property purchases, and the easing of interest rates.

Project Wickenby Yields More Results for ATO

Australia's multi-agency anti-offshore tax evasion initiative Project Wickenby has netted another victory for the Australian Taxation Office. This one involved generating false deductions using false invoices to sham offshore entities. The whole scheme is a blatant sham, and it is not clear how much difficulty was involved in its discovery. A promoter who handled the sham transactions was involved, and whether or not he proved to be the weak link in this case the obvious point is to be careful who you choose to do business with.

Australia's multi-agency crackdown on offshore tax evasion has scored yet another victory after two former Brisbane company directors were last week sentenced to three years by the Queensland District Court for tax fraud. The scheme was investigated by the Australian government-funded Project Wickenby Taskforce, which has so far resulted in 28 people being charged on indictable offenses.

Christopher Cornell and Ian Cameron pleaded guilty to two counts of obtaining a financial advantage by deception. The conviction related to a tax fraud designed to reduce the taxable income of a large Brisbane-based liquor business in 2002 by using offshore companies. The scheme involved around A$300,000 in false deductions claimed on sham invoices. These funds, less a 10% promoter fee, were returned to the company directors.

The conviction is the result of a partnership between the Australian Federal Police (AFP) and the Australian Taxation Office (ATO) in tackling fraudulent offshore schemes. Other Wickenby partners include the Australian Crime Commission, Australian Securities and Investments Commission and Commonwealth Director of Public Prosecutions (CDPP) with support from the Australian Transaction Reports and Analysis Center (AUSTRAC).

Tax Commissioner Michael D'Ascenzo said the ATO has worked closely with the AFP over a number of years to identify the use of false invoices, sham loans and international tax fraud. ...

So far 23 criminal investigations have been brought under Project Wickenby. In addition, 249 tax audits have been completed (another 352 are underway), with A$207 million (US$136 million) in tax liabilities raised and A$79 million in extra taxes collected.

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