When a government plans to do something unpopular, they try to hide it.
For instance, when the Democrats decided last month to renew the draconian Patriot Act, they hid it in a medicare reform bill. They originally tried to hide it in a Pentagon funding bill.
It turned out to be a very successful strategy because it was almost totally ignored by the major media. In fact, it was so successful that last week Congress slipped in what might be the most ominous law of the year.
The law in question was the HIRE Act.
The bill includes $17.5 billion in tax cuts, business credits and subsidies for state and local construction bonds, and moves $20 billion into the highway trust fund for spending on highway and transit programs. It exempts businesses that hire unemployed workers from paying the payroll security tax through December of 2010.
The bill was radically scaled down from the original $150 Billion that might have made a real dent in the unemployment rate.
Obviously no journalist from the major media bothered to read the huge bill. It required the blogoshpere to unearth the gem. Buried in the bill at page 27, under the subtitle of "Foreign Account Tax Compliance" was this critical tidbit:
SEC. 1471. WITHHOLDABLE PAYMENTS TO FOREIGN FINANCIAL INSTITUTIONS.
‘‘...(b), the withholding agent with respect to such payment shall deduct and withhold from such payment a tax equal to 30 percent of the amount of such payment.
This act applies to any account over $50,000. What's more, the law also requires foreign financial institutions to give complete information about the account's identity. Banks that fail to comply for any reason are required to close the accounts.
‘‘(A) The name, address, and TIN of each account holder which is a specified United States person and, in the case of any account holder which is a United States owned foreign entity, the name, address, and TIN of each substantial United States owner of such entity.
‘‘(B) The account number.
‘‘(C) The account balance or value (determined at such time and in such manner as the Secretary may provide).
It is no secret that some of the wealthy of this country, not to mention drug dealers, the mob, and corrupted bankers, hide their money overseas to avoid taxes. This law will not be kind to them. No one is going to shed a tear on their behalf.
But let's be clear - this act doesn't discriminate. It goes after everyone that isn't politically connected enough to get an exemption through the Treasury. It goes after middle-class Americans who want to retire overseas in cheaper nations, or any investor who wants to diversify their life savings by nation.
In essence it is capital controls by proxy.
I believe its main effect will be to further restrict access for U.S. citizens—especially those living in the United States—from offshore banks, brokers, and other foreign financial services companies. This is likely to occur because the cost for these companies to continue doing business with Americans will increase sharply when these portions of the law become effective.
"control of capital movements, both inward and outward, should be a permanent feature of the post-war system."
- John Keynes
Since the 2008 crisis the whole world has been moving towards capital controls. It's already law that the rich must buy their way out of American citizenship. Before the crisis hit there was near universal agreement that capital controls created distortions in the market, therefore they were to be avoided.
That opinion hasn't changed. What has changed is the decision that those distortions are the lesser evil compared to full-scale meltdowns of the financial system. Even the IMF has come around to this point of view.
Capital controls on inflows can be very useful for avoiding bubbles in the economy. The problem is that if you have a trade agreement with the U.S., chances are they are illegal. The Bush Administration made sure of that for the trade agreements with Chile and Colombia.
It isn't capital controls on inflows that concern me. It's capital controls on outflows that do.
Governments create capital controls on inflows to prevent a bubble. They create capital controls on outflows to stem the damage from when a bubble bursts.
For instance, when Iceland's financial system collapsed on October 9, 2008, Iceland's central bank set up restrictions on the private purchase of foreign currencies.
At the time the Krona had virtually collapsed. The capital controls have since been considered a success since they eventually stabilized the currency.
But let's look at it from the point of view of a citizen of Iceland with some savings. On October 15, 2008, the exchange rate was 150 Kronas per Euro. Today that rate is 174 Kronas per Euro. By preventing the people of Iceland from moving their money into other currencies, they effectively prevented them from avoiding losses.
That may seem like mild, acceptable losses given the extent of currency collapse that preceded it, but it isn't always that way.
On December 2, 2001, Argentina imposed currency controls on not just outflows of capital, but even on how much money you could take out of the bank. Those controls weren't lifted for a year. During that time the Argentina Peso was devalued from a 1-to-1 ratio with the dollar, to a 4-to-1 ratio. People's savings were forcibly converted from dollars to pesos using the old ratio. The savings of the people of Argentina were wiped out.
Historically, the Argentina example is much more common when capital controls are imposed (see Thailand 1997). That is why they are so feared.
What does this have to do with America?
Spain recently voiced interest in selling dollar denominated bonds. They are only the latest country to enter this market. Portugal, Russia, and Germany have already done so.
While there are a lot of reasons given for this trend, one thing is for certain - the only way it makes economic sense to sell bonds denominated in another currency is if you expect that currency to decline in the future. Otherwise you will end up paying a far higher price.
Two days before the HIRE act was passed, and the same day that Portugal sold its dollar-denominated bonds, Moody's released a report saying that America's AAA rating was in danger.
A downgrade would affect more than American pride. The bigger risk would be to the country’s ability to keep borrowing money on extremely favorable terms, and therefore to keep spending more money than it takes in from tax revenue.
Historically, Moody's is not on the cutting edge for these things. Generally they only make these announcements after everyone in the market has already figured it out and priced it in.
Another factor that must be considered is that this week marks the end of the Federal Reserve's program of buying $1.25 Trillion worth of mortgage-backed securities. Like Moody's warning, the end of this program is expected to cause interest rates to rise significantly.
It appears that the major players in the world's currencies are betting that America's current low interest rates and currency strength are about to expire. In anticipation, the federal government is preparing to prevent any potential flight out of the dollar.
Someone will lose from this arrangement, and that someone is anyone with dollars in their pockets.