Photographer Marion Post Wolcott on assignment for the Resettlement Administration at Stinking Creek, Pine Mountain, Kentucky
Ilargi: Ben Bernanke says the Fed didn't know about Lehman's Repo 105 creative accounting. Even though the Fed (the New York Fed under Tim Geithner, to be precise), already alarmed over Bear Stearns' demise, had people, supposedly "experts", inside Lehman's offices, who, again supposedly, had access to all relevant books. Maybe they didn't find the quarterly reports relevant to Lehman's situation? The Fed was not alone: the SEC also had placed a team inside Lehman's organization. And the SEC also claims it had no knowledge of Lehman's repos.
(Former) Merrill Lynch people, however, say they warned both the Fed and the SEC about "the way Lehman measured its liquidity position for competitive reasons", back in March 2008. So not only did the two state agencies have people in place, these people also could have known exactly where to look for improper actions. And they didn't look.
I guess there's two questions here: First, what reason would Merrill people have to lie about this two years later, in March 2010? And second, what reason would Geithner, Bernanke, and SEC head Mary Shapiro have to lie about it? Or did the Merrill guys perhaps send their warnings to the ladies who pour the coffee in the Fed and SEC buildings? That might explain the prevailing ignorance. Then again, those ladies tend to talk a lot, so maybe that would have been a better way to go about making the concerns known.
It is way past high time to start investigating both the bankers and the politicians and civil servants who have been, and are, involved in all the opaqueness that still shrouds the truth of what has gone on the past decade on Wall Street. Barry Ritholtz evokes this image: "Like the last scene in Spartacus, I want to see a row of heads on pikes, and crucifixions stretching from Washington DC to Wall Street. I am beyond disgusted."
And by the way, Ritholtz wrote that while commenting on the fact that the SEC joined 12 Wall Street institutions in an effort to repeal legal regulations instituted in 2003: The [..] pact included a complete separation of research and banking staffs, budgets and chains of command—and a physical separation of the two operations. [..] The 2003 settlement led to changes in how securities firms operate. During the Internet bubble, some analysts publicly suggested investors buy stocks, even as the analysts disparaged the companies in private emails. The companies usually were investment-banking clients of the analysts' firms.
Now, I know what RItholtz means, but I don't think heads on spikes is the way to go. Yet. Investigations are, though, and not the small time in the shadows kind, but the thorough out in the open kind. As I said before, Tim Geithner should be put on temporary leave pending such investigations, and there are many more in Washington who should meet the same fate. Bernanke and Shapiro come to mind. Perhaps we should make them understand we're doing them a favor that way: it's either that or face Barry Ritholtz. I'd say that the lack of arrests, investigations and convictions thus far will be a rapidly growing threat to the Obama presidency as we move into the summer and beyond. And if Sarah Palin were smarter (that's not hard), she would be clamoring for exactly these sorts of investigations. That would get a lot of votes.
Pensions are getting hammered down the wazoo, taxes of all sorts are rising (and new ones invented), mass lay-offs for government workers on all levels are just around the corner, foreclosures keep on coming, unemployment numbers are getting ever uglier, in short the picture of a nation (of many nations) is turning both bleaker and darker by the day. And some party or some politician is bound to stumble upon a copy of Spartacus some day soon, and think: That's it!! Bread and games! And a lot of people in New York and Washington will be seen scrambling for the exits.
Money Out Of Thin Air: Now Federal Reserve Chairman Ben Bernanke Wants To Eliminate Reserve Requirements Completely?
Up until now, the United States has operated under a "fractional reserve" banking system. Banks have always been required to keep a small fraction of the money deposited with them for a reserve, but were allowed to loan out the rest. But now it turns out that Federal Reserve Chairman Ben Bernanke wants to completely eliminate minimum reserve requirements, which he says "impose costs and distortions on the banking system". At least that is what a footnote to his testimony before the U.S. House of Representatives Committee on Financial Services on February 10th says. So is Bernanke actually proposing that banks should be allowed to have no reserves at all?
That simply does not make any sense. But it is right there in black and white on the Federal Reserve's own website....
The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.
If there were no minimum reserve requirements, what kind of chaos would that lead to in our financial system? Not that we are operating with sound money now, but is the solution to have no restrictions at all? Of course not.
What in the world is Bernanke thinking?
But of course he is Time Magazine's "Person Of The Year", so shouldn't we all just shut up and trust his expertise?
The truth is that Bernanke is making a mess of the U.S. financial system.
Fortunately there are a few members of Congress that realize this. One of them is Republican Congressman Ron Paul from Texas. He has created a firestorm by introducing legislation that would subject the Federal Reserve to a comprehensive audit for the first time since it was created. Ron Paul understands that creating money out of thin air is only going to create massive problems. The following is an excerpt from Ron Paul's remarks to Federal Reserve Chairman Ben Bernanke at a recent Congressional hearing....
"The Federal Reserve in collaboration with the giant banks has created the greatest financial crisis the world has ever seen. The foolish notion that unlimited amounts of money and credit created out of thin air can provide sustainable economic growth has delivered this crisis to us. Instead of economic growth and stable prices, (The Fed) has given us a system of government and finance that now threatens the world financial and political institutions. Pursuing the same policy of excessive spending, debt expansion and monetary inflation can only compound the problems that prevent the required corrections. Doubling the money supply didn’t work, quadrupling it won’t work either. Buying up the bad debt of privileged institutions and dumping worthless assets on the American people is morally wrong and economically futile."
The truth is that the financial system that we have created makes inflation inevitable. The U.S. dollar has lost more than 95 percent of the value that it had when the Federal Reserve was created. During this decade the value of the dollar will decline a whole lot more.
That doesn't sound like a very good investment.
But that is what happens when you give bankers power to make money up out of thin air.
And things are only going to get worse.
Especially if Bernanke gets his way and reserve requirements are eliminated entirely.
The U.S. economy is a giant mess already, and we have got a guy at the controls who simply does not have a clue.
It's going to be a rough ride.
Michael Moore: Remove money from politics
Bernanke: No Knowledge of Lehman’s "Repo 105"
Bit of a central bank rockstar tour this afternoon, with Fed Reserve Chair Ben Bernanke and former Fed chair Paul Volcker having addressed the U.S. House of Representatives’s Financial Services Committee [Wednesday] afternoon.
Following prepared remarks by both men, in which they defended the Fed’s right to maintain regulatory power over banks, Rep. Spencer Bachus (Rep., Alambama) went right to the issue of Lehman Brothers, asking Bernanke if the Fed knew about the “Repo 105″ accounting method that turns out to have been at the heart of Lehman’s financial shenanigans in 2008 before it went bankrupt.
Essentially, the Fed didn’t know anything, Bernanke replied:
Bachus: Was the NY Fed aware that Lehman Brothers was using an accounting gimmick, Repo 105?
Bernanke: The Fed Reserve was not the supervisor of Lehman Brothers. We did not have that information. We had only a couple people in the company to make sure we were getting paid back the money we lent Lehman under our primary dealer credit facility. We would not have the authority to address accounting and disclosure issues in that context.
Bachus: In the course of the stress tests [the Fed ran on Lehman], wouldn’t you have had the authority to see if they were using an accounting gimmick?
Bernanke: No, sir, these were liquidity stress tests [...] They failed all three tests, and that was information we shared [...] We assessed the value of the collateral, we added a haircut, and we were repaid in full. Again, we were not charged with supervising the company [...] Clearly, it was a very troubled company, and if we’d had some kind of provision to take a non-bank into receivership, we would have taken that.
Volcker chimed in to note that this was a good reason for giving the Fed more power, not less.
Volcker: This is why we need some thoroughgoing reforms, so an institution of that size would have some oversight.
Earlier, SEC chair Mary Schapiro told Congress that the SEC similarly had people on site at Lehman in 2008 but was not aware of Repo 105.
SEC, Fed Alerted By Merrill of Lehman Balance Sheet Games in March 2008
by Yves Smith
So which theory is it: stunning bureaucratic incompetence, wishful thinking and denial (a better gloss on theory #1) or a cover up? Or a combination of the above? No matter which theory or theories you subscribe to, the continuing revelations of how the SEC and perhaps more important, the New York Fed conducted themselves in the months before Lehman’s collapse paint an increasingly damning picture.
The Valukas report shows both regulators were monitoring Lehman on a day-to-day basis shortly after Bear’s failure. They recognized that it has a massive hole in its balance sheet, yet took an inertial course of action. They pressured a clearly in denial Fuld to raise capital (and Andrew Ross Sorkin’s accounts of those efforts make it clear they were likely to fail) and did not take steps towards any other remedy until the firm was on the brink of collapse (the effort to force a private sector bailout as part of a good bank/bad bank resolution).
One of the possible excuses for the failure to do more was that the officialdom did not recognize how badly impaired Lehman was until too late in the game to do much more than flail about. But that argument is undercut by a story in tonight’s Financial Times.Merrill warned both the SEC and the Fed in March 2008 that Lehman was engaging in balance sheet window dressing of a serious enough nature for it to put pressure on Merrill (as in it was making Merrill look worse relative to the obviously impaired Lehman).
When a company under stress makes fraudulent statements about its financial condition, it is a sign of desperation, and possibly imminent collapse. The fact that Merrill, with a little digging, could see that Lehman’s assertions about its financial health were bogus says other firms were likely to figure it out sooner rather than later. That in turn meant that the Lehman was extremely vulnerable to a run.
Bear was brought down in a mere ten days. Having just been through the Bear implosion, the warning should have put the authorities in emergency preparedness overdrive. Instead, they went into “Mission Accomplished” mode. This Financial Times story provides yet more confirmation that Geithner is not fit to serve as a regulator and should resign as Treasury Secretary. But it may take Congress forcing a release of the Lehman-related e-mails and other correspondence by the New York Fed to bring about that outcome.
From the Financial Times:Former Merrill Lynch officials said they contacted regulators about the way Lehman measured its liquidity position for competitive reasons. The Merrill officials said they were coming under pressure from their trading partners and investors, who feared that Merrill was less liquid then Lehman… In the account given by the Merrill officials, the SEC, the lead regulator, and the New York Federal Reserve were given warnings about Lehman’s balance sheet calculations as far back as March 2008. Former and current Fed officials say even in the competitive world of Wall Street, it is unusual for rival bankers to relay such concerns to the Fed.
The former Merrill officials said they contacted the regulators after Lehman released an estimate of its liquidity position in the first quarter of 2008. Lehman touted its results to its counterparties and its investors as proof that it was sounder than some of its rivals, including Merrill, these people said… “We started getting calls from our counterparties and investors in our debt. Since we didn’t believe the Lehman numbers and thought their calculations were aggressive, we called the regulators,” says one former Merrill banker, now at another big bank…
Merrill officials said their calculations led them to believe that Lehman included what is known as regulatory capital in its calculation of excess liquidity. Executives at other banks say that is improper… Mr Valukas said in his report that the banks interacting with Lehman may have suspected Lehman was incorrectly calculating its liquidity. In September 2008, days before it collapsed, Lehman maintained that it had about $50bn in readily accessible funds, though at the end it had nothing like that amount.
JPMorgan also used accounting gimmick
JPMorgan Chase recorded some repurchase trades as sales, the same accounting gimmick that spawned Lehman Brothers’ now-infamous “Repo 105s”, suggesting that the failed bank was not alone in its interpretation of a new accounting rule. Unlike Lehman, which never disclosed the effects of its repo deals on the firm’s balance sheet, JPMorgan detailed the year-end values of its repo sales and purchases in annual reports beginning in 2001, after a new accounting rule was introduced. The practice ended in 2005 when the company merged with Bank One. “The transactions were done in very small amounts and were fully disclosed,” a spokesman said.
Lehman’s use of repo sales as a means to shrink its balance sheet was revealed last week by Anton Valukas, who was appointed in January 2009 by a US court to determine the causes of what was the largest bankruptcy filing in US history. Mr Valukas reported that Lehman’s Repo 105 volumes spiked sharply at the end of a quarter as executives tried to shrink the balance sheet to make the bank appear stronger. Repo trades have long been a vital source of funding for investment banks, and typically remain on the firms’ books. But under certain circumstances banks can account for the trades as a sale and thereby remove them from their books.
JPMorgan’s accounts list sales – the sort of deals Lehman undertook – and purchases, which imply it acted as a counterparty for others doing the same trades. Its counterparty is not thought to have been Lehman, and JPMorgan was not named in Mr Valukas’s report. The bank said the deals were part of an individual trading strategy, not a balance sheet management tool. Although Lehman channelled its deals through its London office to take advantage of a local legal opinion, JPMorgan’s trades were conducted in New York.
Unlike a broker-dealer such as Lehman, whose balance sheets were a literal snapshot of its positions at the end of each quarter, a commercial bank like JPMorgan reports average figures, making quarter-end “window-dressing” irrelevant. In 2004, the last year the trades were done, JPMorgan reported $20bn in sales and $15bn in purchases. At the time, its balance sheet had swollen to more than $1,200bn following the acquisition of Bank One, a US regional lender. JPMorgan Chase bought Bank One in 2004 to bolster its consumer-lending businesses and insulate the company from the often-volatile results of its investment and corporate banking operations.
The deal also gave William Harrison, JPMorgan’s chief executive at the time, a success he had failed to cultivate himself; Jamie Dimon, a former Citigroup executive who had run Bank One, was named president. Not long after Mr Dimon’s arrival, he began to gut the combined company’s management team, replacing Mr Harrison’s deputies with his own longtime lieutenants. Three months after the JPMorgan-Bank One deal closed, Mr Dimon removed David Coulter as investment-banking chief and Dina Dublon as chief financial officer.
SEC Didn’t Act on Lehman’s ‘Problematic’ Liquidity
The U.S. Securities and Exchange Commission didn’t take action after determining in June 2008 that Lehman Brothers Holdings Inc. was exaggerating the liquid assets on its books, the bankruptcy examiner’s report shows. Lehman counted a $2 billion deposit at Citigroup Inc. among cash-like assets available in an emergency, even though withdrawing the money could have impaired Lehman’s trading, according to last week’s report by Anton Valukas. SEC employees viewed the asset’s designation as "problematic," yet didn’t intervene, his report said.
The findings highlight a gap between Lehman’s view of its so-called liquidity pool, used to pay bills in a pinch, and that of the SEC in the months before Lehman filed the biggest U.S. bankruptcy in September 2008. As the financial crisis gathered momentum, investors got only Lehman’s version. "They were saying they didn’t have a problem," said Peter Sorrentino, who helps oversee $13.8 billion at Huntington Asset Advisors in Cincinnati. "Well, they did. It just wasn’t being disclosed." The silence of regulators, who were focused on stability rather than honesty with investors, was invoked as a defense as Valukas quizzed more than 100 executives and other witnesses about the financial health and reporting at Lehman, based in New York.
"A recurrent theme in their responses was that Lehman gave full and complete financial information to government agencies," Valukas wrote. They told him that "the government never raised significant objections or directed that Lehman take any corrective action." Valukas didn’t draw conclusions about whether the SEC’s interactions with Lehman were appropriate. Mary Schapiro, who became SEC chairman in January 2009, has replaced most of the agency’s top officials. The SEC allows firms to determine how they disclose liquid assets, so long as they don’t deceive investors. "We are looking closely at the examiner’s findings as part of our ongoing review of the accounting and disclosures of major financial institutions and their role in the financial crisis," SEC spokesman John Nester said.
U.S. Representative Spencer Bachus today asked the House Financial Services Committee to hold a hearing on Valukas’s report. The Alabama Republican wants witnesses including former Lehman Chief Executive Officer Richard Fuld, former SEC Chairman Christopher Cox, and Tim Geithner, the ex-president of the Federal Reserve Bank of New York who is now Treasury secretary. "Either the SEC and the New York Federal Reserve failed to discover the ongoing accounting fraud at Lehman, or they turned a blind eye," Bachus said. "In either case, the actions of these two regulators represent a grave failure."
On June 16, 2008, Lehman finance chief Ian Lowitt told analysts on a conference call that Lehman’s $45 billion liquidity pool, composed of cash instruments, government and agency securities, and overnight loans, had "never been stronger." Three months later, on a Sept. 10 call, Lowitt said the figure had slipped to $42 billion as the firm reduced outstanding commercial paper. Five days after that, Lehman filed for bankruptcy.
Behind the scenes, the SEC had been questioning how Lehman calculated its figures. The SEC deemed assets to be liquid only if they were convertible to cash within 24 hours. Lehman afforded itself five days. In prior years, the SEC had periodically objected to assets included in the liquidity pool, prompting the firm to remove them. In 2008, though, the agency didn’t challenge the Citigroup deposit. The SEC told Lehman it preferred the shorter limit and never enforced it, according to the report. "If the SEC feels that there is a real shortfall in the company’s liquidity, they’re not serving investors by suppressing that," said John Coffee, a securities law professor at Columbia University. "The obligation is to disclose all material information."
The New York Fed learned Aug. 20 that Lehman had pledged $5 billion in additional collateral to JPMorgan Chase & Co., and didn’t pass the information to the SEC, Valukas said. The SEC learned of the pledge "late" that month, and was told by a Lehman executive that it wouldn’t affect the pool, the examiner said. The SEC didn’t know that JPMorgan had demanded that Lehman post additional collateral during the week of Sept. 8, 2008. It wasn’t aware of any significant issues with Lehman’s liquidity pool until Sept. 12, when officials learned that a large portion of it had been allocated to clearing banks as collateral so that they would keep providing essential services.
In a Sept. 12 e-mail, one SEC employee wrote, "Lehman’s liquidity pool is almost totally locked up with clearing banks to cover intraday credit," according to an e-mail cited by Valukas. "This is a really big problem." The SEC’s examiners at Lehman didn’t belong to the agency’s ranks of investigators and disclosure specialists. Instead, they were part of the Consolidated Supervised Entities program, set up in 2004 to guard against the collapse of systemically important bank holding companies including Goldman Sachs Group Inc., Morgan Stanley, Bear Stearns Cos. and Merrill Lynch & Co. The unit primarily monitored Lehman for financial or operational weaknesses. The agency’s hallmark mandate is investor protection.
A week after Lehman’s collapse, then SEC-Chairman Christopher Cox testified to Congress that the CSE program was fundamentally flawed. No law authorized the voluntary program to prescribe a companywide liquidity level or enforce SEC leverage requirements, he said. The SEC announced Sept. 26, 2008, the program was ending. "It looks like the SEC was behaving much like a bank regulator and trying to avoid public disclosure of information which could encourage either raids, short selling, or possibly a run on the bank," Coffee said. "I think the SEC got itself compromised here."
SEC Tried to Ease Curbs
Judge Rejects Bid by Agency, Wall Street to Soften Landmark 2003 Analyst Deal
The Securities and Exchange Commission joined 12 Wall Street firms in seeking to scrap a key portion of a landmark 2003 deal that put strict curbs on stock analysts, a move that could heighten the ongoing debate about a broad overhaul of the financial-regulatory system. In a ruling Monday, U.S. District Judge William H. Pauley III in New York rejected a proposed change to the legal settlement put in place to end abuses on Wall Street. The proposal would have allowed employees in investment-banking and research departments at Wall Street firms to "communicate with each other…outside of the presence" of lawyers or compliance-department officials responsible for policing employee conduct—an activity strictly prohibited by the settlement.
The settlement came soon after the bursting of the technology-stock bubble, which was caused in part by overly optimistic reports from Wall Street analysts that sent stocks soaring. After the bust, it was revealed that many of those analysts were touting stocks at the behest of their firms' investment-banking operations, which were profiting from initial public offerings. One solution to the conflict of interest was separating the analysts from the investment-banking operations. "The parties' proposed modification would deconstruct the firewall between research analysts and investment bankers erected by the parties when they settled these actions," Judge Pauley wrote in his ruling. Approving the request by the SEC and securities firms "would be inconsistent with" the settlement "and contrary to the public interest."
SEC spokesman John Nester said the agency believes there are other restrictions in place, such as keeping analysts and bankers physically separate and prohibiting bankers from influencing analyst coverage decisions. In a letter requesting the change, the SEC and banks had stated "it is appropriate to eliminate" certain provisions because the conduct is now covered by new rules and regulations. Securities firms covered by the settlement, including Goldman Sachs Group Inc., Morgan Stanley and the Merrill Lynch & Co. unit of Bank of America Corp., declined to comment.
The attempt to lift the curbs comes amid intense discussion over the future of American financial regulation. In the wake of the financial crisis, which many lawmakers contend was exacerbated by lax government oversight, the Obama administration is trying to push through stricter regulation of banks and securities firms. The SEC is at the heart of the battle because of its mistakes during the crisis. On Wednesday, SEC Chairman Mary Schapiro said the agency's oversight of Lehman Brothers Holdings Inc. might have been ineffective, partly because of insufficient staffing. Also yesterday, the head of enforcement at the Financial Industry Regulatory Authority, Wall Street's self-regulatory body, resigned. Like the SEC, Finra has been criticized for failing to detect abuses that led to the crisis and didn't uncover the Ponzi scheme run by Bernard Madoff.
Some outsiders expressed surprise that the nation's top securities watchdog sided with Wall Street in an effort to unwind a major provision of the $1.4 billion settlement. The agreement settled allegations that securities firms issued overly optimistic stock research in order to win lucrative investment-banking business. "I am all for judges being the hero, but isn't the SEC supposed to be?" said James D. Cox, a law professor at Duke University. "The issue of communication between analysts and bankers was at the heart of the entire issue that led to the global settlement. My initial question is: Who at the SEC allowed this to happen?" The SEC spokesman said the commission approved its staff's recommendation.
The 2003 pact included a complete separation of research and banking staffs, budgets and chains of command—and a physical separation of the two operations. Analysts were prohibited under the settlement from even speaking to investment bankers unless someone from the firm's compliance department was present. The firewalls were aimed at prohibiting improper communications. The settlement allows the firms and SEC to seek a judge's approval to change the agreement under certain circumstances. For example, Barclays PLC last year won permission to modify some provisions as a result of its September 2008 acquisition of large chunks of the collapsed Lehman Brothers Holdings Inc. The SEC didn't oppose that request.
In a letter to the judge, Lewis J. Liman, a lawyer representing the securities firms, said the Chinese wall is no longer needed because of securities regulations enforced by Finra. The securities firms and SEC "believe that these rules adequately address the concern intended to be addressed" in the original settlement, Mr. Liman wrote. Mr. Liman couldn't be reached for comment Wednesday. Judge Pauley, who approved the settlement, also couldn't be reached. Harvey Goldschmid, a SEC commissioner when the settlement was reached, said the judge's ruling "was right." "The separation of investment banking from the analysts was a wise thing when we approved it in 2003, and I would not change it," he said. "The firms can argue it would be more efficient to allow the contact, but sometimes when you're talking about very marginal efficiency, there's reason to keep rules that are clear and enforceable."
The 2003 settlement led to changes in how securities firms operate. During the Internet bubble, some analysts publicly suggested investors buy stocks, even as the analysts disparaged the companies in private emails. The companies usually were investment-banking clients of the analysts' firms. Regulators came down hard on the firms and analysts, and the crackdown led to thousands of lawsuits from small investors who relied on tainted stock research. Under the settlement, securities firms agreed to additional disclosures about their operations, payments to investors and other changes. The companies pledged to sever analysts' compensation from investment banking and tie it instead to the accuracy of their ratings. As of Dec. 31, $397.4 million in claims had been paid out to investors, according to a report filed last month with Judge Pauley.
The judge has periodically revised the settlement at the request of the SEC and securities firms. In addition, some provisions of the pact have expired, including a five-year requirement that the companies pay for independent research reports and share them for free with their clients. The joint proposal, filed in a letter to the judge in August, would have allowed "research personnel and investment banking to communicate with each other, outside the presence of internal legal or compliance staff, regarding market or industry trends, conditions or developments, provided that such communications are consistent in nature with the types of communications that an analyst might have with investing customers," according to a court filing.
A copy of the request was made public by the court Wednesday. The judge approved other changes proposed by the SEC and firms, including a request to remove from the settlement deal a provision requiring that research departments have their "own dedicated legal and compliance staff."
States Hope for a Rich Uncle
Governors Lobby Washington for More Money as Stimulus Aid Starts to Run Out
Strapped states, facing up to $180 billion in budget deficits in the next fiscal year, are going hat in hand to Washington. California wants $6.9 billion in federal money for the next fiscal year, and Republican Gov. Arnold Schwarzenegger says he'll have to eliminate state health and welfare programs without it. Illinois, facing a $13 billion deficit that equals roughly half of the state's operating budget, has what it dubs a stimulus team and a group in Washington pressing for additional state aid.
Among other things, Illinois is hoping the federal government will keep paying a higher share of Medicaid costs. "That's $600 million we desperately need," said Kelly Kraft, a spokeswoman for Democratic Gov. Pat Quinn's budget office. Those funds already are counted in the governor's budget proposal. But in Congress, members are balking at further subsidies amid an election-year outcry over the U.S. deficit and federal involvement in the economy. That tension sets up fierce battles as states work out budgets for the fiscal year beginning July 1. Because they can't run deficits, most states face yet more tough choices: raise taxes, cut services, lay off workers or trim employees' wages and benefits over union opposition.
"Our demand for services continues to grow, especially with underemployment and high unemployment—and we expect this trend to continue as we enter what is expected to be a slow-growth recovery," said Anna Richter Taylor, a spokeswoman for Democratic Gov. Ted Kulongoski of Oregon. That Western state passed two tax increases this year but still expects a $2.5 billion budget gap for the 2011-2013 period; officials are seeking an extension of federal stimulus aid as well as other funds from Washington.
About a third of last year's economic-stimulus package went to aid states, including $90 billion to help with Medicaid costs and $54 billion for schools and general services, the largest items in states' budgets. Supporters hoped the money would tide over the states for the worst of the recession. But now those funds have almost all run out. Quarterly payments of Medicaid money are scheduled to end in December, and states will have spent most of their education funds by June. While the economy is starting to improve, unemployment remains high, leaving states with sliding tax revenue and rising costs for welfare services. The total combined gap in state budgets for the 2011 fiscal year, which begins July 1, 2010 in most states, could be as much as $180 billion, according to the liberal Center on Budget and Policy Priorities.
Many states have already raised taxes and curbed services; Hawaii, for instance, closed its schools on 17 Fridays this year. Now states are girding for more cuts as they craft budgets for the next fiscal year. The Virginia general assembly Sunday adopted a budget cutting millions of dollars from schools and public-safety spending. Nevada's lawmakers reached a deal with the governor to cut education spending by 6.9% but preserve some Medicaid benefits including eyeglasses, dentures and adult day care.
President Barack Obama said last month he was concerned about the potential for state and local government layoffs "because we haven't re-upped" money for states. Christina Romer, chairwoman of the White House Council of Economic Advisers, called for more help for states in a speech last week. So far, though, proposals for more money for states have struggled in Congress. Lawmakers wrestled to get a $25 billion provision extending the Medicaid funding by six months, first attaching it to health-care legislation, then to a different bill that the Senate passed last week. Almost half of the states had declared ahead of the vote that their budgets for next year were based on the expectation that they would get the money.
A House jobs plan passed in December included more aid for states' schools and general services budgets, bumping its price tag up by about $24 billion. The legislation stalled in the Senate amid opposition from Republicans and some moderate Democrats to additional large spending measures. Rep. George Miller (D., Calif.), chairman of the House Education and Labor Committee, last week introduced state aid provisions as part of a new $100 billion jobs plan. But he acknowledged the proposal faces hurdles getting through the Senate. Rep. Tom Price (R., Ga.), the leader of the conservative Republican Study Committee, called Mr. Miller's plan a bailout and $100 billion slush fund. Don Stewart, a spokesman for Senate Minority Leader Mitch McConnell (R., Ky.) said he expected to see bipartisan concerns about more deficit spending in any new aid proposals that came to the Senate.
California has been particularly vocal in describing its fiscal woes to Washington in the past year. Mr. Schwarzenegger has prodded the California congressional delegation to bring home more federal money by blasting them on national television, saying they haven't done enough for the state. He has visited Washington to meet with the delegation and with President Barack Obama. Leaders of the California legislature have also lobbied on Capitol Hill for more aid. But groups that lobby on behalf of states, including the Council of State Governments, National Conference of State Legislatures and National Governors Association, say they have little hope of getting much more. "There just doesn't seem to be the political will to address that issue," said David Shreve, a lobbyist for NCSL.
Government use of 'stealth' taxes on rise
France, promising to improve the environment, is planning to introduce a carbon tax. In Finland, where the government says it wants to improve diets, taxes are back on candy and soft drinks. Similarly, Denmark has added tobacco and some fatty foods to the list of taxed products. Britain is taking a different tack, considering a so-called horse tax. All these taxes may be presented as serving virtuous ends, but they also have something else in common: they help plug budget holes deepened by the recession, bailouts and billions in stimulus spending.
At a time when political leaders in Europe and the United States are committed to no additional income-tax burden on the middle class, they also share the advantage of raising revenue without drawing too much attention to the tightening fiscal noose. As a result, analysts say, taxpayers from California to Copenhagen should brace themselves for more "stealth taxes" - indirect levies like sales taxes, or micro-charges on services once provided free, like registering a pet. Such charges can have many benefits for tax collectors. For one thing, they are less volatile and less dependent on the economic cycle than corporate or income taxes. For another, they are less prone to avoidance and cheaper to collect. Finally, analysts say, they are generally easier to enact.
"Politics comes into it," said Stephen Matthews, a tax expert at the Organization for Economic Cooperation and Development. Raising income taxes is more of a "last resort," he said. Not that income taxes are entirely off the table. President Obama has vowed to restore the higher tax rates of the Clinton era on those earning more than $250,000 (U.S.) a year. And the British government just returned its top rate on high incomes to 50 per cent after years of declines. But those increases are focused on the wealthy. Given the public anger over the cost of bailing out the financial system, the idea behind such measures, Mr. Matthews added, is to be seen as tough on the rich.
But countries like Denmark, the Netherlands, France and Belgium already set their top rates around 50 per cent, and sometimes higher. For most countries, there is no room to go much further. President Nicolas Sarkozy of France, for example, was elected in 2007 promising to put more disposable income in people's pockets. In the areas of income, corporate and wealth taxes, he has kept his pledge, capping increases. But with the bills from the financial crisis now landing - and the deficit rising - he is becoming more creative. The taxpayers' pressure group Contribuables Associes claims that since Mr. Sarkozy was elected, at least 20 new taxes have been introduced, including one on crustaceans and mollusks to help pay for a rebate on diesel fuel for fishermen. Copayments for some medications have gone up, as well as television license fees.
An official from the office of Eric Woerth, the French budget minister, disputed the group's figure, saying it was much lower. The official, who spoke only on condition of anonymity, said that the overall fiscal burden for households and companies had fallen under the government of Mr. Sarkozy. Other countries have leaned toward increasing or extending the value-added, or sales, tax. The average VAT rate in the European Union climbed to 19.8 per cent in 2009 from 19.5 per cent in 2008. It would have been higher except for a temporary cut in Britain that expired in January. A survey by the accounting firm KPMG in October said that the average VAT rate in Europe would hit 20 per cent this year or next.
Beyond the taxes on unhealthy foods, Denmark recently removed tax exemptions on travel agencies, property management and the supply of buildings and land. Finland, besides resurrecting taxes on candy and carbonated drinks, raised the VAT rate. "There will also be a mixed bag of other indirect taxes and smaller stealth taxes, which combine revenue generation with others goals like improving the environment," Niall Campbell, global head of indirect tax at KPMG, said in an interview by telephone from Dublin. Britain raised the duty it adds to airplane tickets last year, and it will jump again on Nov. 1. While billed as an environmental tax, the revenue goes directly into the Treasury, critics say. The Institute for Fiscal Studies, a British research group, estimates that revenue from air duties will almost double to £3.3-billion by 2014.
France has announced plans for a carbon tax, intended to encourage conservation. It would be levied on fuels as a proportion of their emissions. It is supposed to be revenue-neutral, with a range of exemptions. Critics, including the opposition Socialist Party, argue that it will fall disproportionately on the poor.
Other taxes are focused even more narrowly. Last year, Northern Ireland announced that it would raise the cost of a dog license tenfold to £50, ostensibly to better tackle the problem of strays and violent attacks. London released a draft bill in January that would establish an animal health body, the cost to be met partly by livestock owners. Equestrians have called it the horse tax and are angry that a leisure industry will have to pay for a measure to aid farmers, who already receive payouts from the European Union. Di Grissell, a former jockey and the owner of Grissell Racing, a racehorse training facility in East Sussex, England, expects her personal income and business to be squeezed. "The government's being very crafty by bringing in back-door tax increases," she said. "The good guys - people who work and are trying to build businesses - are being taxed to the hilt."
A similar trend is playing out in the United States. In 2008, Winter Haven, Fla., started charging "accident response fees" to move the financial burden of tending to accidents directly to at-fault drivers. This month, Nevada officials drafted an emergency regulation to raise entrance fees and season passes for state parks to help plug a gap in state funds, according to The Associated Press. Data from the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution, shows that the total state and local government revenue as a percentage of personal incomes has been steadily rising since the start of the last decade. By contrast, experts said, most Western governments will not tinker with corporate tax. Those receipts naturally fall during downturns as companies earn less. Corporate tax is also seen as a zero-sum game, as raising rates could lead companies to flee to lower-tax jurisdictions.
In recent years, the overall tax burden has been volatile. Among counties belonging to the Organization for Economic Cooperation and Development, based in Paris, tax rates were highest around 2000, then dropped in response to the dot-com recession, before rising again. "Governments have tended to use the benefits of new growth over the past decade to cut taxes rather than improve public finances," Mr. Matthews of the OECD said. "They thought that growth was sustainable," he added. "In hindsight, it clearly wasn't."
28% of British adults out of work, official figures show
A total of 10.6 million people either did not have a job, or have stopped looking for one, according to figures from the Office for National Statistics, which indicated that more people than ever before had abandoned the workplace – choosing instead to study, go on sick leave or just give up searching for a job. A record 149,000 left the workforce and became "economically inactive", between November last year and January, the ONS said. These people more than offset the fall in the headline unemployment. Unemployment fell for the third month in a row, dropping by 33,000 to hit 2.45 million. It has yet to breach the symbolic 2.5 million mark, let alone the 3 million barrier that haunted the recessions of the early 1990s and 1980s.
However, economists immediately expressed caution about the monthly figures from the Office for National Statistics. The total number of economically inactive hit 8.16 million, the highest since the ONS started recording this measure in 1971. The number out of a job, or economically inactive totals 10.6 million, or 28 per cent of adults of working age. The biggest rise in economic inactivity was down to the increase in students, with nearly 100,000 deciding to study in the last three months.
John Philpott, the leading employment economist, at the Chartered Institute of Personnel and Development said: "Unemployment is sharply down, however you measure it. Yet there are also 54,000 fewer people in work, with full-time jobs particularly hard hit. The apparent paradox is explained by a very sharp rise of 149,000 in the number of economically inactive people, with the number of students surging by 98,000. Jobless young people are thus turning to study in their thousands to avoid the dole."
There were also a 18,000 increase in the number of people staying at home to care for children or parents to hit 2.3 million, while the long-term sick failed to fall and stayed at 2 million. The ONS said that of the 8.16 million economically inactive people, 2.3 million have said they would like a job. Theresa May, the Shadow Work and Pensions Secretary said: "What the headline figures don’t show is that many people have simply given up looking for work. One in five people of working age you meet won’t have a job.
"Britain needs a credible plan on jobs and growth so that the 2.3 million people looking for jobs who don’t appear in the official unemployment figures can get back into the workplace." Added to the economically inactive, were a further 1.04 million part-time workers that were on reduced hours because they could not find a full-time job. Experts also pointed out that the only jobs being created were in the public sector, with 22,000 created by central government, mostly in the NHS. Ironically, one of the biggest institutions hiring new workers are Jobcentres, which took on 2,250 new workers in the last three months.
In contrast, employment in the public sector fell by 61,000. Mr Philpott added: "Whether or not benign headline jobless figures limit the potency of unemployment as a vote clinching issue in the forthcoming General Election campaign, whoever forms the next Government will face a Herculean task in its efforts to return the UK economy to full employment within this decade." Yvette Cooper, the Work and Pensions Secretary, said: "The fall in unemployment for the third month in a row is very welcome, but we should remain cautious. "We're not out of the woods yet and we are still determined to do more to support jobs and help the unemployed this year."
Bank of England fretting about 'zombie households'
Charlie Bean, deputy governor of the Bank of England, is worried about zombie households. That, at least, is one of the lines buried away in his speech to Cambridge Univerisity alumni last night, which is well worth reading in its entirety. In our story, we focused this morning on his calculation that Quantitative Easing has effectively cut the government’s cost of borrowing by a full percentage point (more than the IMF had calculated in working paper not so long ago). The implication is that as and when it’s withdrawn we should prepare ourselves for a big increase in government interest rates. Ouch.
But Bean’s comments on the state of the broader economy are well worth a look. In particular, he seems to be rather worried about:
1. The fact that we are living in a quite different world when it comes to borrowing – pace this:
"We should not expect premia to return to where they were before the crisis broke. The spreads on lending to businesses and households, particularly riskier prospects, will be higher in the future than before the crisis."
2. The likelihood that we’re left, after this crisis, with a load of zombie households. Of course, he doesn’t put it quite like that, instead saying:
"the housing boom has resulted in some households, especially younger ones, carrying forward high levels of debt. Although the burden of servicing these debts is currently manageable because of the low level of mortgage interest rates, concerns about future servicing costs as interest rates normalise may lead the high stock of outstanding debt to weigh on these households’ spending."
3. The fact that the pound’s depreciation hasn’t yet boosted exports. He seems convinced, still, that it will do eventually, but doesn’t seem to be holding his breath quite as stubbornly as before.
"Commentators have noted that exporters have responded to the depreciation by expanding their profit margins rather than cutting their foreign currency prices in order to boost market share. Does this mean that the depreciation will prove ineffective at boosting demand? I do not think that would be the right conclusion. Experience after previous large depreciations, such as following sterling’s exit from the Exchange Rate Mechanism in 1992, suggests that it is normal for the initial impact to be seen mainly in expanded profit margins and only after some while does one see an impact on market shares. One reason for that may be that expansion in overseas markets requires some investment and businesses are likely to be cautious about making that expenditure until they are sure the improvement in profitability will be maintained. For that reason, I expect to see the contribution from net exports gradually building as the global recovery proceeds."
The gist, though, is simple: the scars will take a long, long time to heal. This is no normal recovery.
It is a message which is reinforced by the minutes to the Monetary Policy Committee’s latest meeting. Although the minutes show – as expected, that the MPC was unanimous in leaving everything on hold, it seems it, too, is worried about the force of the headwinds currently facing the economy. Like the US Federal Reserve, they remain far more reluctant to embark on exit strategies (more appropriately called “re-entry strategies”) with the economy still so close to the edge.
Will they get it wrong and leave monetary policy too accommodative for too long? History suggests they will, but it also suggests this is probably the best of a bad bunch of outcomes.
Markets spooked as Greek rescue plan crumbles
by Ambrose Evans-Pritchard
Europe’s rescue plan for Greece appears to be crumbling after the country threatened to call in the International Monetary Fund unless Brussels comes up with real money on acceptable terms within a week. The inability of the eurozone to put together a viable package after a month of talks has dismayed markets, which thought the terms of a deal had already been agreed. Yields on 10-year Greek bonds spiked 17 basis points yesterday to 6.26pc. The euro fell two cents against the dollar to below $1.36. "The facade of unity among eurozone members hardly held for more than a day," said Beat Siegenthaler from UBS.
Greek Premier George Papandreou told the European Parliament that his country was running out of patience. It is in effect already subject to the full rigours of an IMF-style austerity plan but without enjoying any of the benefits. He said the savings from cost-cutting measures were vanishing into the pockets of bond-holders through higher interest rates. "We have the worst of the IMF and none of the advantages. This is where Europe must come in and provide what the IMF can offer. Or Greece will have to go to the IMF. We hope that will not be necessary," he said.
"I prefer a European solution as part of the eurozone, to show the world that Europe can act together. This is not to ask for money but to have an instrument on the table to stop the speculation. We expect the EU to live up to the challenge facing it. We are a eurozone country," he said. Hungary was better off with a "free currency", able to work with the IMF outside the eurozone. "Papandreou is playing poker," said Silvio Peruzzi from RBS. The defiant tone leaves no doubt that this escalating game of brinkmanship has turned deadly serious. If Mr Papandreou is bluffing, his bluff is likely to be called since a German-led bloc of states is also warming to the IMF be the best way after all to maintain EMU discipline.
Such a course enables Chancellor Angela Merkel to avoid a legal battle at Germany’s top court over breach of the EU’s `no-bail-out’ clause; it avoids a deeply unpopular decision before the regional elections in May; and it leaves the Fund’s experienced fiscal police in charge of austerity. Mr Siegenthaler said the Greek story "is far from resolved and will continue to haunt the Euro." Vague rhetoric from EU finance ministers is no longer enough to satisfy markets. "Greece is trying to deliver fiscal adjustment of a magnitude unprecedented in post-war Europe. Naturally, this will create serious social and political tensions. In the absence of economic growth, Greece will need access to cheap financing if it is to escape a debt spiral."
Sources in Washington say Greece can expect to borrow from the IMF at around 3.25pc. While the EU has not specified its own terms, the Eurogroup said this week that any help would come at a punitive rate above the borrowing costs for other EU states, suggesting a rate of 4pc to 5pc. Mr Peruzzi said the IMF route is fraught with danger, even if it looks tempting in the short-run. "It completely undermines the credibility of monetary union. It would show that EMU is not viable because it lacks the fiscal means to absorb shocks. If they can’t help out a small country like Greece, its not worth going on with the project. That is what is worrying the markets," he said.
He said Italy and several other states are quietly willing to go along with an IMF solution because it spares them the extra burden of raising fresh debt to help pay for a standby fund. "They don’t want to disburse any cash of their own. This is definitely on their minds," he said. Germany appears to have deeper objections to an EU bail-out, fearing that it would be the first step towards EU fiscal union and shared responsibility for debts, leaving German tax payers on the hook for over €3 trillion in Club Med debts. The concerns appear to be shared by Finland and the Netherlands, which have both backed recourse to the IMF.
Mr Papandreou said his country did not want charity. "We are not asking for money from the Germans, Italians or French, what we are saying is that we need strong political support for reforms and to make sure that we do not have to pay more than necessary. We need to borrow at rates that are normal, similar to the rates other states in the EU and eurozone can use," he said. Mr Papandreou said speculators were the cause of his country’s woes and demanded that Europe "put the loaded gun on the table" to deter attacks by hedge funds. This argument is starting to irritate Berlin, where it is seen as a ploy to absolve Greece for responsibility for its own troubles, and to circumvent legal restrictions on EU aid.
Mrs Merkel told the German Bundestag on Wednesday that Greece’s trouble were home-grown and had almost nothing to do with speculators. Hammering home the point, she said the EU Treaties should be changed to allow the expulsion of countries eurozone "as a last resort" if they persistently breach the rules. The comment caused consternation in EU capitals, suggesting for the first time that Germany no longer view EMU an unbreakable and eternal fraternity. "Chancellor Merkel’s comments are very worrying," said Guy Verhofstadt, former Belgian premier and now head of Europe’s Liberals. "This is a very bad signal," said Udo Bullmann, chief finance spokesman for Germany’s Social Democrats. "This plays straight into the hands of the enemies of the European Project."
However, Mr Papandreou is in danger of exhausting sympathy in other EU states. His game of playing off the EU and IMF against each other has begun to irk fellow leaders, and his insistent claim that Greece is the victim of speculators may be unwise in any case. It creates the impression that the country has been cut off from access to the capital markets. By demonizing credit default swaps his rhetoric may discourage investors from buying Greek bonds, since many use these contracts to hedge their holdings. Deutsche Bank chief Josef Ackermann said the furore over CDS swaps showed a "basic misunderstanding" of modern finance. Ireland has overcome its confidence crisis by resisting the temptation of shoot the market messenger and by projecting an image of worldly sophistication. Analysts say Greece would do well to learn the lesson.
Greece May Seek IMF Help by Easter Weekend
Increasing pressure on the European Union, Greece may seek financial help from the International Monetary Fund over the April 2-4 Easter weekend if no detailed rescue plans are forthcoming from the EU, a senior Greek official said Thursday. Disappointed that another round of meetings by senior EU and euro-group officials this week failed to produce concrete steps to help Athens in its scramble for funds, the Greek government is now looking with scant optimism toward an EU summit next week, the official said.
"We still want a solution within the European Union, but it doesn't look good," the official said. "If there is no clear support at the EU summit on March 25, we will have to decide where to go next," he said. "There are a number of scenarios on the table, but the most prominent one is the IMF." The German financial ministry this week warned Greece not to expect detailed financial aid package from next week's meeting of EU heads of government. Prime Minister George Papandreou is "in steady contact with" IMF Managing Director Dominique Strauss-Kahn, the official added. The IMF, which has been giving Greece technical assistance on the debt crisis, has said it stands ready to help.
Mr. Papandreou said Thursday he has talked to the IMF as high interest rates are wiping out the steps Greece is taking to reduce its debt levels. The steps Greece is taking are those that would have been mandated by the IMF, he told the European Parliament. "They would ask nothing more," he said. "We have the worst of the IMF" without the benefits of an IMF loan, he said. Mr. Papandreou said he still would prefer a European solution, but the senior official said hopes were fading, especially as a rift with Germany over the crisis was deepening. Greece's minister of economy, competitiveness and shipping, Louka Katseli, told local media Wednesday the chance of going to the IMF was 70%.
Greece's debt crisis—the government last year admitted to a budget deficit of 12.7% of gross domestic product, triple the EU limit—has spooked global markets in recent months, battering the euro on worries that Athens might default and that contagion could spread to other indebted euro-zone economies like Spain and Italy. The EU has made general pledges of support for Greece, but Germany, the EU's biggest economy, is notably reluctant to give any aid. Athens argues that it needs help such as loans, guarantees or bond purchases to lower what is says are crippling borrowing costs.
Despite Greece's series of painful budget-cutting tax increases and spending cuts that have caused mass protests, investors demand a yield of some 3 percentage points higher for Greek 10-year bonds than for German bunds. Greece, which has sold €18 billion ($24.73 billion) worth of bonds out of this year's total borrowing needs of €54 billion, must redeem some €22 billion of bonds in April and May. It isn't clear how much the Greek threats to go to the IMF are meant to put pressure on the EU to come up with aid, but Germany at least appears unruffled at the prospect of an IMF rescue for a euro-zone member. A person in the Berlin government said Tuesday that "Germany would be open to an intervention" by the IMF if euro-zone countries deemed it "a one-time necessity."
Germany's position toward Greece appears to be hardening. Chancellor Angela Merkel told Parliament Wednesday she wants a mechanism that could in the future exclude euro-zone countries that repeatedly fail to abide by its standards. While such an idea is seen as having almost no chance and Mr. Papandreou said there was "zero possibility" of Greece leaving the euro zone, Ms. Merkel's comments further soured the bilateral mood. "The rift with Germany is widening instead of narrowing," the senior official said. "There is an increasing belief in the government that the IMF will be the only solution."
As for the timing of a potential IMF aid request, the official said no decision would be made until after next week's EU summit but that the long Easter weekend—the Western and Greek Orthodox holidays coincide this year—would allow "time for the news to be absorbed" while markets were closed. Greece had been planning to raise €10 billion through one or two bond sales this month, but the senior official said such plans are now likely on hold until after the EU summit. "One thing is for sure," he said. "We will not go to the market again with these barbaric interest rates because this is a recipe for bankruptcy."
Greece, the euro, and the Battle of Jutland
by Ambrose Evans-Pritchard
During the Battle of Jutland in 1916 or Skagerrakschlacht as it is known in Germany, the Imperial German Navy carried out a brilliantly executed "battle about turn" after straying into a death trap beneath the guns of the Royal Navy’s Grand Fleet. Admiral Scheer’s High Fleet vanished into the mists within four minutes — his retreat covered by a torpedo attack and the "death ride" of four German battlecruisers that charged into Admiral Jellicoe’s guns in an act of supreme sacrifice. The actions saved the Imperial High Fleet. It has gone down in German history as the Gefechtskehrtwendung.
I was unaware of this until it was brought to my attention by Commerzbank this morning in a note by their currency chief in Frankfurt, Ulrich Leuchtmann. He drew the parallel with the astonishing volte-face by German leaders yesterday in suggesting that Greece should go to the IMF for a rescue after all. "A Gefechtskehrtwendung is a 180-degree turn that saves you. I think this may save Germany from a bail-out that they don’t like, that they can’t sell to German voters, and that creates legal problems under the no-bail-out clause of Article 125 of the EU Treaties. We think the IMF is the ideal solution anyway, and would actually be good for the euro. It would establish discipline and avoid moral hazard. It is much easier for the IMF to enforce austerity conditions," he said. "The markets are still focused on the fact that we still don’t seem any closer to an EU rescue for Greece, so they are treating this IMF story as negative," he said.
I agree entirely with Dr Leuchtmann. The EU top brass have of course been saying for weeks that it would be intolerable to let the camel’s nose of Washington’s IMF under the eurozone tent. Eurogroup chair Jean-Claude Juncker said it would shatter the credibility of monetary union. But is this all EU religious stuff: ideology and totemism. Mr Juncker, the Commission’s Jose Barroso, and their allies, have been trying to exploit the crisis to advance the EU Project, pushing the boat stealthily across the Rubicon towards fiscal federalism and a de facto debt union. They hoped that the Germans would not realize fully what was being done to them until too late. Chancellor Angela Merkel appears to have balked at this – understandably — seeing a standby facility for Greece as the beginning of a slippery slope that would leave German taxpayers on the hook for €3 trillion of Club Med debts.
At least that is how I interpreted her comment yesterday that one should "perhaps call in the IMF". The plot thickened when her Christian Democrat finance spokesman in the Bundestag, Michael Meister, said: "We have to think who has the instruments to push Greece to restore access to capital markets: nobody apart from the IMF has these instruments." No doubt there will be further utterings today. This morning, Greek premier George Papandreou openly threatened to go to the IMF in an address to the European Parliament. These are the quotes that have just been relayed to me by our very sound Brussels Correspondent Bruno Waterfield.
"We are not asking for money from the Germans, Italians or French, what we are saying is that we need strong political support for reforms and to make sure that we do not have to pay more than necessary." "We need to borrow at rates that are normal, similar to the rates other states in the EU and eurozone can use." "In fact we are under an IMF programme. However we do not have the facilities that the IMF could give – money if necessary." "Greece, unlike Hungary does not have a free currency. We have the worst of the IMF and none of the advantages of the eurozone. This is where Europe must come in and provide what the IMF can offer. Or Greece will have to go to the IMF, we hope that will not be necessary."
So Hungary has a "free currency" and is therefore better off? I am shocked, shocked, that he could say such a thing. "I prefer a European solution as part of the eurozone, to show the world that Europe can act together." "We expect the EU to live up to the challenge facing it. We are a eurozone country. Within the eurozone, where we have one currency, we should have similar types of loans, not the same kind of loans, so we can be competitive. That is not only viable but a realistic demand. As I said, this instrument may never be used but the fact that it does exist is going to be a very important political and financial tool to support Greece in its needs for going out to the market."
Is this now a dispute about the price of any loan? Or are the Greeks so angry over the barrage of insults they have been receiving daily that they would almost relish a chance to give Brussels a black eye in revenge? The Eurogroup has suggested that any rescue would come at a punitive rate above EU borrowing costs, but did not specify. Perhaps it would be around 4.5pc to 5pc for long-term money. Sources tell us that the IMF would lend at around 3.25pc, using its SDR benchmark plus 100 basis points. So why suffer the daily abuse from Europe?
Besides, as Mr Papandreou himself said, the IMF "would have asked us for nothing more," meaning it would not impose more severe austerity measures than the EU is already imposing. It would be lunacy to do so. Greece is already having to squeeze fiscal policy by 10pc of GDP in three years — and a lot more if Deutsche Bank is right in predicting economic contraction of 4pc this year. If you think through the arithmetic, this could soon turn into a self-defeating downward spiral. It is quite possible that the IMF would impose more rational — ie more lenient — terms. Though how on earth IMF strategists would deal with this crisis is beyond me. They usually demand a devaluation of 30pc or so to offset the pain of fiscal austerity and to allow the country to claw its way out of its hole through exports and import substitution. This is obviously Verboten in euroland.
Latvia is going through a version of this IMF-pain-without-an-IMF-cure treatment, it its case to defend its euro-peg. The IMF expects the result to be a 30pc contraction of GDP from peak to trough, just about a world record. Not surprisingly, the ruling coalition disintegrated yesterday, unable to agree on how to implement this euphemistically named "internal devalulation". Latvia is being crucified for the sake of EU fixed-exchange ideology. I would be cross if I were Latvian. Needless to say, it really doesn’t make any difference in the long-term whether Greece gets a bail-out or who provides the money. The country is not facing a liquidity crisis, it is facing an insolvency crisis. Stephen Jen from BlueGold Capital says the EU authorities appear to misunderstand the fundamental nature of the problem. Greece needs a "Thatcherite" supply-side revolution (good luck with PASOK) to raise its game. This cannot be done when the country is caught in a vicious circle of deflationary wage cuts and fiscal retrenchment. So Greece too must be crucified for ideology, until it too loses a government. What a way to run a railroad.
El-Erian Says IMF to Aid Greece After ‘Chicken’ Game
The International Monetary Fund will come to the rescue of debt-strapped Greece after a "game of chicken," according to Mohamed El-Erian, co-chief investment officer at Pacific Investment Management Co. "The IMF will come in, but it’s going to be a bumpy process," said El-Erian, who is also chief executive officer of Newport Beach, California-based Pacific Investment Management Co., in an interview on Bloomberg Radio. "There is no immediate solution. Don’t underestimate the game of chicken between Greece, the EU and the IMF."
Greece’s Prime Minister George Papandreou set a one-week deadline for the European Union to craft a financial aid mechanism for Greece, challenging Germany to give up its doubts about a rescue package. Greece, which had the European Union’s widest budget deficit at 12.7 percent of output last year, has struggled to convince investors it can bring the shortfall within the bloc’s limit of 3 percent. Papandreou said he may turn to the IMF to overcome Greece’s debt crisis unless EU leaders agree to set up a lending facility at a summit March 25-26. The IMF option has been dismissed by European Central Bank President Jean-Claude Trichet and French President Nicolas Sarkozy, who say it would show the EU can’t solve its own crises.
"Europe cannot come up with the financing that Greece needs and Europe cannot impose conditionality on Greece," El Erian said. "We have seen the movie over and over again where a country runs into a fiscal issue. The key thing for investors is to not to rush in on the first evidence of anything, but to wait. This is a very complicated process of bringing together enough domestic support for a meaningful adjustment process and financing." German Chancellor Angela Merkel, who says Greece won’t need a bailout, told parliament in Berlin yesterday that in the absence of a European lender of last resort, calling in the IMF "would probably have to be the way out right now if action were to be taken."
German 10-year government bonds were little changed today after four days of gains as investors sought the safest euro- denominated assets. The yield on the security earlier dropped as much as two basis points, or 0.02 percentage point, to 3.09 percent before trading at 3.12 percent. Countries with Aaa sovereign ratings aren’t under immediate risk of losing that status and only an inability to reverse fiscal erosion would prompt a reduction, according to Moody’s Investors Service.
Among the biggest countries with Aaa sovereign ratings, the U.S. and U.K. face greater threats to their ratings than France and Germany, which have relied less on the government to fuel their economies, Moody’s said in a conference call with investors on March 16. The risk to ratings comes amid an economic recession that began in December 2007 and the worst decline since the Great Depression. The U.S. and U.K. sought to counter the effects through government-funded stimulus, and each spend about 7 percent of revenue servicing debt in 2010, assuming a moderate recovery, Moody’s said.
"There has been a very sharp increase in debt to GDP in the United States -- over 20 percentage points" El-Erian said. "That was unthinkable. What Moody’s is saying is that unless we see a credible medium term fiscal adjustment program there is a risk debt indicators will get to a level that is incompatible with as Aaa rating." The U.S. budget deficit widened to a record $221 billion in February as the government boosted spending to help revive the economy. Treasury Department figures show the deficit this year will likely surpass the record $1.4 trillion in the fiscal year that ended in September.
Pimco’s Bill Gross, who runs the world’s biggest bond fund at Newport Beach, California-based Pimco, has increased holdings of bonds from non-U.S. developed nations for a fourth month, taking them to the highest level since May 2004. Gross raised the proportion of the securities in the Total Return Fund to 19 percent of assets in February from 18 percent in January, according to a report placed on the company’s Web site yesterday. He increased U.S. government debt to 35 percent from 31 percent, the first increase since October 2009, and lowered net cash to 2 percent from 9 percent.
Angela Merkel defies IMF and France as anger rises over German export surplus
by Ambrose Evans-Pritchard
German Chancellor Angela Merkel has defied France and the IMF, refusing to modify Germany’s strategy of export reliance or boost growth to help alleviate the deep crisis sweeping Southern Europe. "Where we are strong, we will not give up our strengths just because our exports are perhaps preferred to those of other countries," she told the German Bundestag. Mrs Merkel swept aside criticisms that Germany and other surplus countries are partly to blame for the widening North-South rift that has led to Euroland’s worst crisis since the launch of monetary union. "The problem has to be solved from the Greek side, and everything has to be oriented in that direction rather than thinking of hasty help that does not achieve anything in the long run and merely weakens the euro even more," she said.
Instead she called for EU treaty chnges so that serial violators of EMU rules could be expelled from the euro, and insisted Germany would stick to its own path of hairshirt austerity. The tough words came as the IMF’s chief Dominique Strauss-Kahn said it was time for Berlin to rethink its single-minded pursuit of exports, warning that both Germany and China need to play their part in rebalancing the global system rather than relying on huge structural surpluses. "This must change. Internal demand must be strengthened with more consumption," he told the European Parliament.
French finance minister Christine Lagarde infuriated Berlin earlier this week by suggesting that Germany’s relentlesss wage squeeze was making it impossible for Club Med states to claw back lost competitiveness within monetary union, forcing them into a deflation policy that must ultimately rebound against everybody. "Clearly Germany has done an awfully good job in the last 10 years or so improving competitiveness. When you look at unit labour costs, they have done a tremendous job in that respect. I’m not sure it is a sustainable model for the long term and for the whole of the group. Clearly we need better convergence. While we need to make an effort, it takes two to tango," she told the Financial Times. Mrs Lagarde said yesterday that Germany should cut consumption tax to lift imports and help do its part to narrow the North-South gap.
Her comments have prompted fierce criticisms in Germany. "Mrs Lagarde must take back her outrageous assertions: jealousy should not be a factor in the politics of European neighbours. This is the behaviour of a bad loser," said Alexander Dobrindt, general secretary of Bavaria’s Social Christians (CSU) in the Merkel coalition. Germany has gained some 30pc to 40pc in cost advantage against Italy and Spain since the mid 1990s, and over 20pc against France, according to EU data. Germany’s current account surplus is expected to reach $190bn this year, or 6pc on GDP.
The achievement is remarkable, but is also upsetting the structure of monetary union. David Marsh, author of `The Euro: the Politics of the New Global Currency", said the Germans never faced up to the political implications of EMU. "They thought everybody else should become more German. You can’t blame them for having a desire for a competitive industry and surpluses built into their genes, but they are not thinking holistically," he said. EMU rules are forcing Club Med states to tighten fiscal policy by 10pc of GDP for Greece, 8pc for Spain, and 6pc for Portugal over three years without any offsetting monetary or exchange stimulus, an unprecedented demand that may cause such deep economic damage that it proves self-defeating in the end.
Charles Dumas from Lombard Street Research said the Club Med states and Ireland cannot deflate wages below German levels without causing havoc to their economies, so the EU policy creates a profound bias towards a deflationary slump for the whole system. "The Germans are not very good at arithmetic. If they want to run surpluses near $200bn (£130bn), others must run deficits near $200bn. It is not appropriate that Germany’s dismal growth peformance be exported to the whole of Europe, but that is what is going to happen," he said. "There has been this massive self-righteousness in Germany. They have been leeching off the demand of countries for the last decade, and now they too are going to suffer until they change their ways. German industrial production is down 17pc from the peak and has been flat for four months, so Mittelstand bosses are soon going to draw the obvious conclusion and downsize in style," he said.
Mr Dumas said the trade surplus of the German bloc of Northern states is as great as the combined surplus of China and Asia’s tigers. They are central players in the story of global imbalances. Holger Schmieding, chief Europe economist at Bank of America Merrill Lynch, said attacks on Germany were deeply misguided. The country suffered a long slump after digesting East Germany in the 1990s and was forced to retrench. It did not take part in the global credit boom, acting as a counterweight to excess. Once the bust began it had sufficient fiscal reserves to cushion the shock with large stimulus measures, again acting as a bullwark of stability. "I am still waiting hear the world say `thank you Germany’," he said.
What is Wall Street hiding?
Alabama and Milan make bankers nervous
by Gillian Tett
Are the urbane, excitable citizens of Milan "sophisticated"? What about those of Alabama, USA? That is a question that could – and should – soon be provoking a welter of debate. For while Alabama and Milan are rarely mentioned in the same breath, both locations now share something: they are making bankers nervous. The reason is derivatives. Earlier this week, the city of Milan announced that it is suing Deutsche, UBS, JPMorgan and Depfa, for allegedly misleading the city on swaps that adjusted interest payments on some €1.7bn ($2.3bn) of deals. The banks deny the allegations relating to the case. The trial is scheduled to start in May.
Meanwhile, on the other side of the Atlantic – if not cultural spectrum – another battle has recently played out in relation to bonds and swaps arranged by JPMorgan for the city of Birmingham in Jefferson County, Alabama. Late last year, JPMorgan agreed to pay a $25m civil fine, make a $50m payment to Jefferson County and forfeit $647m in termination fees linked to swaps deals. This came after the Securities and Exchange Commission accused JPMorgan of malpractice (a claim that the bank neither admitted nor denied on settlement).
Now, I have no idea whether an Alabama-style settlement will emerge in Milan too: the legal systems differ, as do the details of the contested trades. However, the really interesting issue is whether this could be about to spark a wider trend. After all – and as the Financial Times reported recently – the Milan deals are just the tip of an iceberg of complex financial deals that have been cut in recent years with Italian entities (including even religious orders). Moreover, those Italian deals are just one fragment of a vast global web of transactions that investment banks have sold to public, and quasi-public entities.
I daresay most of those deals have been arranged in transparent circumstances. Probably many have also left the clients happy. But some have not, particularly in the aftermath of the credit crisis. Thus, the scenario that now worries some senior bankers is that other western municipalities will look at the tale of Birmingham – or Milan – and lodge their own lawsuits. The pain might not stop there. Many local government entities are saddled with public debt that they will struggle to repay. They also know that it is currently fashionable for politicians of all stripes to bash the banks. It is thus easy to imagine a scenario where some local government entities are soon tempted to seek haircuts on derivatives deals in all manner of ways (including legal suits).
And what makes that scenario doubly alarming for banks is that public sector entities do not usually post collateral when they cut derivatives deals; nor do banks usually price them to take account of future potential legal costs. The net result, in other words, is that some senior bankers are now quietly wondering if it is time for them to rethink how they assess and price municipal or local government risk. Whether they will actually do that, remains to be seen. But as the anxiety swirls there is another issue where there is now an even more tangible need for a rethink – the question of what constitutes a "sophisticated" investor.
After all, a key reason why the banks have been able to stuff so many controversial deals into local authorities in recent years is that most bankers and regulators have assumed the world could be divided into two categories. In one box sat retail investors who were safeguarded by consumer protection laws; in the other, sat non-retail – such as Milan – who were considered to be "sophisticated", and thus fair game for the banks’ sales teams. Caveat emptor. But the story of Italy (or Alabama) shows that this two-tier distinction is nuts. Some non-retail investors, such as hedge funds, are "sophisticated", but many pension funds, or public sector entities are not. (In Italy, for example, some government officials purchasing the deals could not even read the English-language contracts).
If nothing else, this suggests that regulators badly need to rethink the two-tiered distinction (perhaps by creating a third, middle category of investors who are neither retail, nor fair game for banks.) In the coming months, Mary Schapiro, head of the SEC, is likely to do precisely that, by calling for a new definition of "sophisticated" investors. European regulators may do the same. However, the banks need to act too, by voluntarily rethinking their definition of "sophisticated" clients. Doing that will not necessarily stave off lawsuits linked to past deals. But it might let them get ahead of the political curve, and even save costs in the long run. After all, legal disputes are costly for everyone (except lawyers) – not just in Milan, but Alabama too, not to mention all the other jurisdictions where more drama could yet emerge.
US Jobless Claims Fall Slightly, Inflation Flat
Claims for unemployment benefits fell slightly last week, a mildly positive sign for the U.S. labor market, while consumer prices stayed flat in February, a sign of little inflationary pressure in the economy. Initial claims for jobless benefits fell by 5,000 to 457,000 in the week ended March 13, the U.S. Labor Department said Thursday. The seasonally adjusted consumer price index, meanwhile, was unchanged last month after increasing an unrevised 0.2% in January. Core consumer prices, which strip out volatile energy and food items and are more closely watched by the Fed, were up a monthly 0.1% in February. In January, core prices fell 0.1%.
Meanwhile, a Commerce Department report showed the U.S. current-account deficit expanded in the fourth quarter to its highest level in a year as rebounding economic activity resulted in higher imports of oil and other goods. All three reports on Thursday suggest the economy is slowly on the mend with inflation under control, leaving scope for the Federal Reserve to keep supporting the economy with record-low interest rates. Thursday's jobless claims report was "indicative of a gradually recovering labor market," said Barclays Capital economist Michelle Meyer. Despite the decrease, however, most economists still note that claims are relatively high. That raises concerns about the recovery's pace and how many Americans are still having a tough time finding work.
The decrease in initial claims was just below economists' expectations. Economists surveyed by Dow Jones Newswires expected initial claims to decrease 7,000. At a hearing earlier this week, Treasury Secretary Timothy Geithner and other top Obama administration officials called the country's current 9.7% unemployment rate "unacceptable," and suggested unemployment may remain elevated for the rest of the year. At the same time, other recent survey data appear to suggest some signs of improvement as companies slowly show less reluctance to hire new full-time workers. So far, claims data has not reflected some of the findings in those surveys.
"Claims first reached their current level nearly four months ago, in late November, and the lack of progress since then is disconcerting," wrote Ian Shepherdson, the Chief Economist at High Frequency Economics in a note. "Claims remain a bit too high to be consistent with increases in private payrolls." On the consumer-price report, the last time inflation looked so tame was in March 2009, when consumer prices fell 0.1%. On an annual basis, which is not adjusted for seasonal factors, consumer prices rose 2.1% in February. Core consumer prices rose 1.3% from 12 months ago, the lowest increase since February 2004.
The Labor Department's report showed that energy prices fell 0.5% on the month, the first decline since April 2009, with the gasoline index falling 1.4%. Meanwhile, the price of used cars and trucks continued to increase, rising 0.7% in February, while the index for new vehicles rose 0.1%. Food prices were up 0.1% last month, with the index for food away from home and food at home both rising 0.1%. Economists surveyed by Dow Jones Newswires expected an increase of 0.1% in both the headline and core consumer price index numbers. Experts said the Labor Department's consumer price report seems to suggest a move toward an environment of disinflation--a temporary slowing in the rate of price increases.
"Overall, these figures show that the disinflationary pressure of the recession is only just starting to be felt," said Paul Dales, the U.S. economist for the Canada-based Capital Economics. "Such trends are likely to keep the Fed on hold for longer than the markets expect and weigh on Treasury yields." Markets are currently placing a high probability that short-term rates will rise by the end of this year.
As for the current-account report, the Commerce Department reported the U.S. current account deficit rose to $115.6 billion from the third quarter's $102.3 billion. The current account measures trade in goods and services, transfer payments, and investment income. U.S. imports of goods rose October through December, with purchases of industrial supplies and oil posting some of the biggest gains. "With most businesses looking to stabilize or modestly boost inventories, underlying demand for imports has picked up substantially," MFR Inc. analyst Joshua Shapiro said.
Dutch pension fund sues Bank of America for $100 million
One of the world's largest pension funds is suing Bank of America for more than $90m (£60m) over its 2008 takeover of Merrill Lynch, claiming the banking giant failed to disclose the full extent of losses at the US investment bank. Dutch Pension fund ABP, which manages $285bn, has filed a lawsuit in New York against Bank of America, accusing the financial group of hiding billions of dollars of Merrill Lynch losses, which if disclosed might have led investors to vote against the merger with Merrill Lynch.
The suit goes on to claim that Bank of America withheld details of a secret document it signed with Merrill Lynch guaranteeing the payment of up to $5.8bn of bonuses to the bank's staff. ABP's lawyer Jay Eisenhofer, managing partner at law firm Grant & Eisnhofer, said: "Had the shareholders known all the facts, they would have been able to make a more informed judgment and possibly prevented a disastrous acquisition."
APG, ABP's in-house investment operation filed the lawsuit, and is seeking as much as $91m in damages from Bank of America. Bank of America declined to comment.
"Prior to the merger date, BofA appear to have had knowledge of record quarterly losses Merrill was facing," AGP said in a statement. "The losses were expected to exceed $15 billion." Bank of America has also faced legal action from the US authorities. The Securities and Exchange Commission has sued the bank twice for "misleading" investors over the bonus payments, fining it $33m in August, before announcing a second $150m settlement last month. Andrew Cuomo, New York attorney general, has been Bank of America's most vociferous critic and has filed a civil fraud charge against the bank's former chief executive Kenneth Lewis, who oversaw the deal. Mr Cuomo has been instrumental in bringing to light many of details surrounding the merger, including the multi-million dollar bonuses paid to some staff.
China in Midst of ‘Greatest Bubble in History,’ Rickards Says
China is in the midst of "the greatest bubble in history," said James Rickards, former general counsel of hedge fund Long-Term Capital Management LP. The Chinese central bank’s balance sheet resembles that of a hedge fund buying dollars and short-selling the yuan, said Rickards, now the senior managing director for market intelligence at McLean, Virginia-based consulting firm Omnis Inc. "As I see it, it is the greatest bubble in history with the most massive misallocation of wealth," Rickards said at the Asset Allocation Summit Asia 2010 organized by Terrapinn Pte in Hong Kong yesterday. China "is a bubble waiting to burst."
Rickards joins hedge fund manager Jim Chanos, Gloom, Boom & Doom publisher Marc Faber and Harvard University professor Kenneth Rogoff in warning of a potential crash in China’s economy. The government has raised banks’ reserve requirements twice this year after economic growth accelerated and property prices rallied. China has pegged the yuan to the dollar since July 2008 to help exporters weather the global recession. The central bank buys dollars and sells its own currency to prevent the yuan strengthening, driving foreign-exchange reserves to a world- record $2.4 trillion as of December. The Shanghai Composite Index of stocks jumped 80 percent last year and property prices rose at the fastest pace in almost two years in February, helped by a record 9.59 trillion yuan ($1.4 trillion) of new loans in 2009.
The World Bank indicated today that China should raise interest rates to help contain the risk of a property bubble and allow a stronger yuan to help damp inflation expectations. The nation’s "massive monetary stimulus" risks triggering large asset-price increases, a housing bubble, and bad debts from the financing of local-government projects, Washington-based World Bank said in a quarterly report on China released in Beijing. "People making comments about bubbles possibly don’t have all the facts," HSBC Holdings Plc Chief Executive Officer Michael Geoghegan said in Shanghai today. Regulators are in control of the banking industry, and have the ability to curb lending as needed, he said.
Rickards said leveraged speculation in the stock market, wasteful allocation of resources by state-owned enterprises, off-balance-sheet debt through regional governments and the country’s human rights record are concerns. "Take Russia and China together, neither of them is really deserving any investment" except for short-term speculation, Rickards said. India and Brazil are two of the "real economies" among the developing countries, he said. China is poised to overtake Japan as the world’s second- largest economy this year, according to the International Monetary Fund, and Nomura Holdings Inc. forecasts it will contribute more than a third of global growth. The nation has surpassed the U.S. as the world’s largest auto market and Germany as the No. 1 exporter.
Harvard’s Rogoff said Feb. 23 that a debt-fueled bubble in China may trigger a regional recession within a decade, while Chanos, founder of New York-based Kynikos Associates Ltd., predicted a slump after excessive property investments.
Investors Bob Doll and Antoine van Agtmael say China’s stock market isn’t a bubble. Equities will gain by the end of the year as the government takes measures to prevent the economy from overheating, Doll, BlackRock Inc.’s chief investment officer for global equities, said on March 5. China is unlikely to face "chaos" or experience a hard landing, Van Agtmael, who helps manage $13 billion as chairman and chief investment officer of Emerging Markets Management LLC, said in a Bloomberg Television interview yesterday.
The Shanghai Composite Index is valued at 32 times reported earnings, compared with 52 times at its peak in October 2007. The U.S. benchmark Standard & Poor’s 500 Index trades at 19 times earnings. China’s economic growth quickened to 10.7 percent last quarter, helped by a 4 trillion yuan, two-year stimulus plan for railways, airports and homes. Property prices in 70 cities rose 10.7 percent from a year earlier in February. Bank loans slowed to 700 billion yuan last month after surging more in January than the previous three months combined, central bank data showed. Growth of the broadest measure of money supply, or M2, slowed for a third month to 25.5 percent.
The banking industry has "very low impairment charges compared to what you’d expect this time in the cycle," HSBC’s Geoghegan said. "I wouldn’t be surprised if there’s a gradual increase in impairments, but long term I’m confident that the structure of the banking industry is very, very sound." Rickards disputed an argument that China could hold U.S. policies hostage through its Treasuries holdings. The nation remained the largest overseas owner of U.S. debt after trimming its holdings by $5.8 billion in January to $889 billion.
China would suffer massive losses if the debt was dumped, reducing the funds available in the U.S. securities market and forcing the prices lower, he said. The U.S. president also has the authority, rarely used, to freeze such positions, he said. Rickards worked for LTCM between 1994 and 1999 and helped to negotiate its rescue by 14 Wall Street firms after the fund lost $4 billion in a few weeks in 1998. The Federal Reserve brokered the bailout on concern that LTCM’s collapse would cause a meltdown in financial markets.
China: the coming costs of a superbubble
by Vitaliy N. Katsenelson
China may seem to have defied the recession and the laws of economics. It hasn't. When China's bubble bursts, the global impact will be severe, spiking US interest rates.
The world looks at China with envy. China’s economy grew 8.7 percent last year, while the world economy contracted by 2.2 percent. It seems that Chinese “Confucian capitalism” – a market economy powered by 1.3 billion people and guided by an authoritarian regime that can pull levers at will – is superior to our touchy-feely democracy and capitalism. But the grass on China’s side of the fence is not as green as it appears. In fact, China’s defiance of the global recession is not a miracle – it’s a superbubble. When it deflates, it will spell big trouble for all of us. To understand the Chinese economy, consider three distinct periods: “Late-stage growth obesity” (the decade prior to 2008); “You lie!” (the time of the financial crisis); and finally, “Steroids ’R’ Us” (from the end of the financial crisis to today).
Late-stage growth obesity
About a decade ago, the Chinese government chose a policy of growth at any cost. China’s leaders see strong gross domestic product (GDP) growth not just as bragging rights, but as essential for political survival and national stability. Because China lacks the social safety net of the developed world, unemployed people aren’t just inconvenienced by the loss of their jobs, they starve; and hungry people don’t complain, they riot and cause political unrest.
Remember the 1994 movie “Speed”? A young cop (Keanu Reeves) had to save passengers on a bus that would explode if its speed dropped below 50 m.p.h. Well, China is like that bus with 1.3 billion people aboard. If the Communist Party can’t keep the economy growing at a fast clip, the result will be catastrophic.
To achieve high growth, China kept its currency, the renminbi, at artificially low levels against the dollar. This helped already cheap Chinese-made goods become even cheaper. China turned into a significant exporter to the developed economies. Normally, if free-market economic forces were at work, the renminbi would have appreciated and the US dollar would have declined. However, had China let this occur, demand for its products would have declined, and its economy wouldn’t have grown at roughly 10 percent a year, which it did during the past decade. The more China sold to the United States, the more dollars it accumulated, and thus the more US Treasuries it bought, driving our interest rates down. US consumers responded to these cheap goods and cheap home loans by going on a buying binge.
However, companies and countries that grow at very high rates for a long time will inevitably suffer from late-stage growth obesity. Consider Starbucks: In 1999, it had 2,000 stores and was adding 1.8 stores a day. In 2007, when it had 10,000 stores, it had to open 5.5 stores a day in a desperate bid to keep growth rates up. This resulted in poor decisions and poor quality – a recipe for disaster. In China, political pressure for full employment has led to similar late-stage growth obesity. In 2005, China built the largest shopping mall in the world, the New South China Mall: Today it’s 99 percent vacant. China also built up a lavish district in a city called Ordos: Today, it’s a ghost town.
All good things come to an end, and great things come to an end with a bang. When the financial meltdown erupted in 2008, US and global banks started dropping like flies. Countries everywhere suffered contraction. Even China. During the crisis, Chinese exports were down more than 25 percent, tonnage of goods shipped through railroads was down by double digits, and electricity use plummeted. Yet Beijing insisted that China had magically sustained 6 to 8 percent growth. China lies. It goes to great lengths to maintain appearances, including censoring media and jailing those who write antigovernment articles. That’s why we have to rely on hard data instead.
Steroids ‘R’ Us
Today the global economy is stabilizing, thanks to Uncle Sam and other “uncles” around the world. But the consumers of Chinese-made goods are still in debt, unemployment is high, and banks aren’t lending. You might think the Chinese economy would be growing at a lower rate. But no, it is growing again at nearly 10 percent, as though the financial crisis never occurred. Though this growth appears to be authentic – electricity consumption is back up – it is not sustainable growth, because it is based on an unprecedented stimulus package and extraordinary government involvement in the economy. In the midst of the financial crisis, in late 2008, Beijing fire-hosed a $568 billion stimulus into the Chinese economy. That’s enormous! As a percentage of GDP, it would be like a $2 trillion stimulus in America, nearly triple the size of the one Congress passed last year.
It gets even more interesting. Unlike Western democracies, whose central banks can pump a lot of money into the financial system but can’t force banks to lend or consumers and corporations to spend, China can achieve both at lightning speed. The government controls the banks, so it can make them lend, and it can force state-owned enterprises (one-third of the economy) to borrow and to spend. Also, because the rule of law and human and property rights are still underdeveloped, China can spend infrastructure project money very fast – if a school is in the way of a road the government wants to build, it becomes a casualty for the greater good. Government is horrible at allocating large amounts of capital, especially at the speed it is done in China. Political decisions (driven by the goal of full employment) are often uneconomical, and corruption and cronyism result in projects that destroy value.
To maintain high employment, China has poured money into infrastructure and real estate projects. This explains why, in 2009, new floor space doubled and residential real estate prices surged 25 percent. This also explains why the Chinese keep building new skyscrapers even though existing ones are still vacant. The enormous stimulus has exacerbated problems that already existed, threatening to turn China into a less shiny but more drastic version of debt-riddled Dubai, United Arab Emirates. What happens in China doesn’t stay in China. A meltdown there – or even a slowdown – would have severe consequences for the rest of the world. It will tank the commodity markets. Demand for industrial goods will fall off the cliff. Finally, Chinese appetite for our fine currency will diminish, driving the dollar lower against the renminbi and boosting our interest rates higher. No more 5 percent mortgages and 6 percent car loans.
No shortcuts to greatness
We look at China and are mesmerized by its 1.3 billion people, its achievements of the past decade, its recent economic resiliency, and its ability to achieve spectacular results on the fly. But we have to remember that economic bubbles are usually just a good thing taken too far. The Chinese economy is no exception. Its long-term future may be bright, but in the short run we’ve got a bubble on our hands. Everyone wants a shortcut to greatness, but there isn’t one. China has been trying to bend the laws of economics for a while, and with the control it exerts over its economy it may seem that it’s succeeded. But this is only a temporary mirage, which must be followed by a painful reality. No, there is no shortcut to greatness – not in personal life, not in politics, and not in economics.
Rethinking China's Debt
Local government debt is the latest smoking gun for those predicting China's economy will eventually run aground. China's high economic growth may continue to smooth over any problems. But that isn't a fix Beijing can keep counting on. The issue is rooted in last year's massive expansion of bank lending. Much of this went to local government-backed investment vehicles, which then funded infrastructure projects across China. Victor Shih, an assistant professor of political science at Northwestern University, reckons debt at these entities reached $1.7 trillion by the end of 2009.
Most will need continuing funding, so that figure could more than double by the end of 2011. Because Beijing supports both the banks and the local governments, this lending should arguably be added to the central government's debt figures. Doing that, Mr. Shih estimates, would make China's debt-to-GDP ratio, around 20% in 2009, closer to 71%. By 2011 that could rise to 96%. Acknowledging this as part of the central government's liabilities does give a truer picture of China's fiscal position. But it still isn't particularly worrying by international standards. The U.S. and U.K., for example, expect similar debt-to-GDP ratios in coming years. Japan's is already far higher.
Anyway, the debt will be a problem for Beijing only if the loans go bad and the central government is forced to recapitalize local governments or the banks. Anecdotal evidence of misplaced investment and corruption make some fear eventual heavy write-offs. But optimists suggest most of the projects that have received funding will prove viable. China's faced similar bad debt problems in the past, and has grown its way out of them. What's left of the nonperforming loans piled up in the late 1990s accounts for a much smaller percentage of GDP now than it did a decade ago.
The same trick could work again, analysts at Gavekal Research figure. Even if China's growth slows to 7% per year on average in the next decade, nonperforming loans will still only rise to a manageable 9% of GDP by 2019, they estimate. Beijing, though, shouldn't imagine such tactics can work forever. One big drawback of China's current debt-fueled growth is that it has set back the cause of making China's banking sector more commercially oriented. The reform path needs to be found again if China's economy is to find a more sustainable long-term footing.
Chinese Official Warns of Risk If Yuan Rises
A senior Chinese trade official warned that any further appreciation of the Chinese currency risked driving exporters out of business, underscoring the domestic political pressures on Beijing amid growing international calls for China to let the yuan rise. Vice Commerce Minister Zhong Shan, in an exclusive interview Thursday ahead of a visit to the U.S., said that the profit margin on many Chinese export goods was less than 2%. Most exporters absorbed the appreciation in the value of the yuan that followed its revaluation in 2005 by boosting innovation and cutting costs, but many were forced to close, he said. A further rise in the currency's value would endanger more exporters' survival, which China can't afford, he said.
U.S. lawmakers and business groups rejected Mr. Zhong's argument, and said China needed to address concerns over its currency if it wanted to avoid further irritating bilateral tensions. Mr. Zhong talked about a potential tipping-point effect to describe the fragile situation of many exporters. "Water doesn't boil if it is heated to 99 degree Celsius. But it will boil if it is heated by one more degree," he said. Likewise, "a further rise in the yuan by a very small magnitude might cause fundamental changes" to exporters in China, he said.
The yuan climbed 21% against the dollar from 2005 to 2008, when China adopted a managed-float currency system under which the yuan's value was linked to a basket of currencies. But the yuan has been kept almost unchanged against the dollar since the outbreak of the global crisis to help Chinese exporters, which has prompted much criticism from abroad. "Vice Minister Zhong's comments underscore that China views its policy as a way to promote China's exports and domestic growth," an aide attached to the Senate Democratic leadership said on Thursday. "Well, that is at the expense of the United States and many other countries. ... It's classic protectionism. China's currency policy distorts global markets to promote growth at home and it is time for it to stop."
Earlier in the week, a bipartisan group of U.S. senators introduced legislation aimed at forcing the Obama administration to take action against China over its currency policy, reflecting growing anger on Capitol Hill over the issue. The bill would require the U.S. to impose tariffs and other penalties on countries that failed to address misaligned currencies. The aide said there was more momentum now among lawmakers to take legislative action on the issue than at any other time over the last several years. "Patience has run out," he said, adding that even if China were to reintroduce a very tightly controlled float, as it did in 2005, "it will not be enough."
Myron Brilliant, senior vice president for international affairs at the U.S. Chamber of Commerce in Washington, said revaluing the yuan wouldn't just address concerns of the U.S. and other countries but also aid China in its effort to tackle domestic inflation and asset bubbles, and to encourage increased domestic consumption. Such a move "is in its own interests," he said.
On Thursday, U.S. Ambassador to China Jon Huntsman, in a speech to students at the elite Tsinghua University in Beijing, called on China to allow "more flexibility" on the yuan exchange rate. Mr. Zhong said that "I fully understand the state of mind of the U.S. government and its people" toward the problem of high unemployment. He pointed out, however, that while the U.S. has a jobless rate of more than 9%, compared with China's urban registered jobless rate of slightly more than 4%, the absolute number of China's jobless is far higher because of its much larger population. China makes no secret of the fact that its currency policy is designed partly to protect jobs in the export sector and thus maintain social stability.
Within Beijing's government bureaucracy, the thinking on exchange rates isn't monolithic. The Chinese Commerce Ministry is under particular pressure from the exporter lobby to defend their interests, and Mr. Zhong's comments reflect that political reality. Labor-intensive exporters have the most to lose from currency appreciation, which erodes their competitiveness. Mr. Zhong said China is willing to purchase more American goods and take other steps to reduce its trade surplus with the U.S. But he urged the U.S. to find a solution at home rather than put pressure on China. He noted that China found ways to cope when tens of millions of workers were thrown into unemployment in the late 1990s when the government shuttered unprofitable state-run enterprises. "When we have a problem, we usually look for the causes internally. However, the U.S. tends to look for reasons from the outside. There's a cultural difference between our two nations," Mr. Zhong said.
As an example of these differences, he said that more than a decade ago when he was chairman of a Chinese textile trading company he noticed that when U.S. business executives visited China "they said they must fly first class and stay at five-star hotels." He claimed he never awarded himself such luxuries. "I wanted to save costs and ease pressures within the company starting from the position of chairman," he said. Mr. Zhong warned that a rise in the value of China's export products could also accelerate inflation in the U.S. and the rest of the world.
However, he carefully avoided saying that China would keep the currency regime entirely unchanged. "We are willing to have discussions with the U.S. on the currency issue.... There's nothing that can't be discussed between China and the U.S. But if you pressure us to do something, that's not in line with China's culture," Mr. Zhong said. Premier Wen Jiabao, at a news conference on Sunday, argued that the yuan isn't undervalued. Mr. Zhong is scheduled to leave Saturday for the U.S., where he will meet U.S. representatives including members of Congress to seek ways to improve the bilateral trade relationship amid rising political and economic tensions.
Earlier this week, Commerce Ministry spokesman Yao Jian said the ministry has been examining the potential impact of a change in the yuan's value on exporters. Domestic media have reported other ministries are conducting similar investigations, dubbed "stress tests." However, economists say this shouldn't be interpreted as a sign Beijing is laying the groundwork for a rapid rise in the yuan in coming months, and some said China could in fact use the studies to argue against an appreciation of the currency in the talks between Beijing and Washington in May.
"Beijing needs to collect more figures to show that it is currently not able to let the yuan appreciate sharply, despite the growing pressure from its trading partners," said Yan Jin, an economist at Standard Chartered Bank. Asked about the recent growing concern among many multinational companies about a worsening business environment in China, Mr. Zhong said China remains one of the most attractive destinations in the world for foreign investment and is determined to open its market further. He said the government has been "seriously studying" the matter and pledged to "correct quickly if any errors are found."
Europe facing commercial property timebomb
Europe faces a commercial property debt timebomb with almost €1 trillion (£896bn, $1,36 trillion) outstanding from the sector and a quarter of that potentially distressed. The UK accounts for 34pc of the €970bn total, with Germany second with 24pc, new research shows. The scale of commercial property debt in the UK, and the precarious nature of much of it, has been flagged by the Bank of England and the Financial Services Authority as a threat to the recovery of the economy and the banks, but the report by CBRE highlights that it is an issue for most of Europe.
According to the property agent, €207bn of the debt is secured at high loan-to-value ratios on poor quality real estate, and is therefore most at risk of not being repaid. Of this, €89bn, or 43pc, is from the UK, and €69bn from Germany.
Also, the debt is maturing at a rate of €155bn a year, meaning almost half will have matured by the end of 2012. There are concerns about the repercussions of the outstanding debt following sharp falls in commercial property values since 2007, which has put pressure on loan-to-value covenants and eroded equity. Tenant failures and declining rents have also affected income for property owners.
Natale Giostra, head of UK debt advisory at CBRE Real Estate Finance, said: "Germany and the UK saw some of the highest levels of gearing at the top of the market in 2006-07 and so are likely to have a higher proportion of problem debt arising from highly geared loans." What banks do with distressed property assets on their balance sheets is the key topic of discussion at the annual Mipim property conference in Cannes. Dennis Watson, managing director of property and project finance at Barclays Corporate, has said the banks are likely to increasingly turn to joint venture and asset management agreements with property companies to nurse their assets back to health.
One leading agent in Cannes with knowledge of the loanbooks of Royal Bank of Scotland and Lloyds stressed they had major exposure to secondary offices and shopping centres outside London – an area where demand from buyers remains weak – meaning widespread asset sales would be difficult. Robin Hubbard, executive director of CBRE Real Estate Finance, said banks could take 10 years to unwind their exposure to distressed commercial property.
The Country of Fiscal Prudence
by Jonathan Tonge
Canada. The land of the strong and free. The land of fiscal prudence. Or so we have been told.
Jim Flaherty has been so surprised that Canadians believe him when he says that we are fiscally prudent, that he has decided to assemble a task force to look into the matter. Headed by Don Stewart from SunLife, the team will dive deep into this quandary. In a conversation with Australian economist Steve Keen, he alluded that he might be involved in this task force as well. He's got a good head on his shoulders. These are the questions he'll be pondering:
- With the Bank of Canada's interest rate set at 0.25%, how is it that 1/3 of Canadians are struggling financially? What happens when interest rates double, and the cost of debt does as well?
- Studies suggest that Canadians are wildly overly optimistic about their financial picture.
- Why Canadians feel that they'll retire comfortably but can't verbalize or explain how that will happen... and they generally start to drool and stutter.
Well I can answer why they feel this way. The government, banks, media and associations in this country keep telling Canadians that they're fine. In fact they brag about how financially responsible Canadians are to people around the world. But here is the reality. We've been living a lie. We've been listening to interested groups of people who of course benefit from our inaction. The truth is we have been anything but financially prudent. This is what Don and Steve will find:
(Note that there has been some confusion on this blog about the following graphs. The graphs show the actual changes to outstanding credit (blue line). They also show two other lines. Both make changes to the 1999 balance only (or 2002 in the case of household credit). The inflation line shows what the credit would look like had the 1999 balance grown at the rate of inflation. The purpose of the disposable income line is to show how much debt would exist if the debt-to-disposable income ratio was maintained at the 1999 level - which even then was a historically high figure)
CREDIT CARD BALANCES - 1999-2010
Credit card balances are up 458% in 11 years.
Please keep in mind that when credit inflation is this large, you have to question its impact on disposable incomes - that is, are those incomes sustainable when the credit ceases to expand or more likely, contracts. They are not and as evidence of this, real wealth gains would drive the debt to disposable income rate down. Real higher incomes provide savings and the ability to pay down debt. The fact that this is not the case, suggests that the incomes and the economy are heavily inflated by debt.
Note that in the graphs I adjusted the total credit outstanding in 1999 to reflect both inflation and disposable incomes over the course of the decade. This gives you an idea of what the 'real' amount outstanding in 1999 would look like today.
(ie. $11.5 billion in 1999 has the same worth as $14.5 billion today)
In 1999, outstanding residential mortgage debt was $399 billion. Eleven years later, it has expanded by 242% to $965 billion.
That looks scary. The $965 billion is the figure quoted most often by the media, and even myself. But it's missing an important trend that has occurred over the past ten years. Canadians have been tapping into the their home equity to finance purchases and mortgages at extraordinarily low variable interest rate through Home Equity Lines of Credit.
PERSONAL LINES OF CREDIT
Home equity lines of credit have become the drug of choice for Canadian consumers. They use them to finance everything from cars to furniture to home renovations, and of course, mortgages.
Between 1999-2010, lines of credit grew 820% to $205 billion.
As a result of credit cards, lines of credit and residential mortgages, household credit has expanded from $669 billion in 2002 to $1.41 trillion in 2009. Despite a small reprieve for a couple months in early 2009, it has been growing by roughly ten billion per month. By the end of 2010, Canada's household debt-to-disposable income will be roughly 155% (currently 146%).
In my next post I'll prove to you that we weren't even in good shape in 1999 or 2002. This trend started in the 1980s. I'll also discuss why economies that are inflated by credit tend to be more stable with shorter and less intense recessions - hence why Canada's economic picture has been so rosy since the mid eighties. In fact the only period where household credit decelerated was during 1990-1995 - look at how that worked out for us. And in this coming credit contraction, you should expect volatility, with recessions occurring on a regular basis every few years. They will be sudden and damaging.
The Pain in Spain ... And What It Means for Europe and Beyond
Spain's rapid decline from one of Western Europe's fastest-growing economies to one of its most troubled has left many looking for blame. How could the country, a poster child for the benefits of European economic and monetary integration, suddenly find itself lumped together with smaller, more sickly economies like Greece, Portugal and Ireland?
Because of its size, Spain's success in reversing its fiscal deterioration is critical for the future of the euro, the European Union and, ultimately, the global economy. "The unfolding of Greece's fiscal imbalances and Dubai's episode represented a first sign of how quickly investors can become risk-averse," analysts from JPMorgan wrote in a research report. If Spain fails to execute a credible plan to cut its budget deficit, the worries over sovereign solvency will spread quickly beyond the small, peripheral countries currently making the most headlines, experts warn. A Spanish default could herald the breakup of the euro and a rise in retaliatory protectionism around the world.
The thought that Spain could default on its debt and require a bailout from fellow EU members -- a course of action Greece is currently considering -- is not going over well in Madrid. In February, Infrastructure Minister José Blanco blamed an "international conspiracy" to damage Spain via "apocalyptic editorials in foreign media." Indeed, around the same time, daily newspaper El País reported that the country's intelligence service was investigating the motives for "speculative attacks" on Spain's economy in the English-language press.
Although it is politically expedient to blame shadowy outside interests for a country's domestic troubles, newspaper columnists and bond vigilantes are marginal actors in Spain's financial drama. According to Franklin Allen, a finance and economics professor at Wharton, the bursting of an enormous construction bubble is to blame for the "desperate problem" Spain now finds itself in.
Bolstered by development funds and low interest rates following its membership into the EU and the arrival of the euro, a building boom over recent years created a dangerously unbalanced economy, with construction accounting for more than 15% of Spanish GDP at its peak. When the global recession dented demand for the holiday homes and investment properties that fuelled the boom, Spain was left with a large economic hole to fill. This is the "heart of the problem," Allen says.
Mauro F. Guillén, professor of international management at Wharton, agrees that the construction bubble is at the center of Spain's current problems, which built up "during the last six or seven years." The bubble goes well beyond housing and commercial real estate to include all sorts of infrastructure, "roads and bridges and railway tracks. All that became a very important part of the economy, to the point that about 45% of all new construction -- not just residential construction but any kind of construction -- in all of Europe was taking place in Spain, when the Spanish economy is maybe 15% of Europe." Construction is highly labor intensive," Guillén adds. When it slows down, "then you have a lot of people out of [work]." (See accompanying video interview with Guillén on this page.)
Spain's GDP shrank by 3.6% in 2009. Another contraction is expected in 2010, in contrast to forecasts for growth in most other large developed countries. Unemployment currently stands at 20%, double the rate of two years ago. The strength of a recovery in 2011 and beyond relies on a raft of policy measures introduced to reduce the yawning budget deficit -- 11.4% of GDP in 2009 -- that is causing so much concern about Spain's creditworthiness. As a condition of membership in the eurozone, the country must reduce its deficit to 3% of GDP by 2013. Although it was running a budget surplus as recently as 2007, reversing the recent slide won't be quick or easy, according to Wharton faculty and others.
Government officials' prickly response to critics of their economic management stems from the fact that, in many ways, Spain avoided the traps other countries fell into during the global financial crisis. Thanks to a conservative supervisory regime, the country's banks were not meaningfully exposed to the toxic securities that felled their counterparts. Spain's level of government debt as a percentage of GDP is also well below the eurozone's average. But no matter how well the government managed its own finances and kept tight reins on banks before the financial crisis, Spain's enormous private-sector debt overhang makes markets justifiably nervous. According to an analysis by consultants at McKinsey, the sum of Spanish government, corporate and household debt relative to the size of the overall economy surpasses all developed countries except the U.K. and Japan. Correcting the imbalance has grave implications for the public purse.
For that reason, observers worry about Spain's ability to service its debts. Bailouts of Greece and Portugal, if necessary, would be "not inconsequential but manageable," according to Witold Henisz, a professor of management at Wharton. The EU-led rescues would probably knock tenths of percentage points off of European growth, he adds. It's a different story with Spain.
In a joint statement, eurozone countries have pledged to take "determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole." If such action amounted to a bailout of Greece or Portugal, the gravity of the situation would immediately bring Spain under intense pressure, considering it is expected to be the next domino to fall. Should it be unable to avoid a rescue, Spain would demand "the same or better terms" as previous aid recipients, Henisz says. Spain is the fourth-largest economy in the eurozone, more than twice as large as Greece and Portugal combined. "When we talk about bailing out [countries] like Spain, the magnitude is pretty daunting," he adds. The effect of such a bailout would knock full percentage points off growth in Europe at a time when economies are in the fragile early stages of recovery.
A Spanish bailout would also usher in a perilous second phase of the global financial crisis, Henisz warns, with large countries -- Italy, for example -- facing default as they became unable to fund budget deficits. The viability of the euro currency would come into question, as the union's stronger members could eventually refuse to prop up weaker members and decide that their destiny would be better served by monetary independence. Spanish officials' lashing out at indistinct foreign culprits is a precursor of what to expect, Henisz says. The risks of a "spiral into protectionist isolationism" would rise. "Political parties that espouse nationalism and xenophobia could get some serious purchase under these conditions."
But whatever the chances of a default in Spain, one thing seems clear -- the country is unlikely to try to solve its current problems by withdrawing from the currency union and returning to the peseta so it can devalue, Guillén says.
For one thing, support for monetary union was highest in Spain, "much higher than in Germany, where a lot of people were reluctant because they already had a strong currency," Guillén says. "So Spain is very pro-European." As a result, the chances of Spain pulling out of the euro are "just unthinkable." But it is also "unthinkable from another point of view, which is that you have a lot of home owners in Spain who have a mortgage. Their mortgages, in 95% of the cases, are variable, [with] adjustable interest rates." Those interest rates are linked to the euro, and if Spain turned away from the euro, then "their mortgage payments would go through the roof.... So there's absolutely no chance that Spain by itself would want to get out of the euro."
Preventing Doomsday Scenarios
The doomsday scenario could be avoided by allowing Greece to default, Allen says. Voters in the EU's stronger countries are loath to support rescues of weaker members, so the talk of a bailout merely "postpones the day of reckoning," he says. It's better for a small eurozone country like Greece to default first so that policy makers "can see how it will play out." Although unwelcome, the experience would steel governments' resolve to push through the short, sharp cuts necessary to bring their finances into line lest they suffer the same fate.
In this respect, Ireland is leading the way, according to Allen. Suffering late last year from the effects of the bursting of a massive property bubble as well as dangerously overextended banks, the Irish government introduced severe austerity measures, including pay cuts of up to 15% for civil servants and reductions in unemployment and welfare benefits. "The effort demanded of every citizen in this budget is substantial, but it is the last big push of this crisis," Irish finance minister Brian Lenihan said when unveiling the measures. He had previously noted that elsewhere in Europe, "you would have riots if you tried to do this."
Spain's recovery plan does not go as far as Ireland's. Indeed, the Spanish government backed down on a proposal to revise the way pensions are calculated when faced with public opposition. Nevertheless, the latest package of tax hikes, spending cuts and phase-outs of stimulus measures adds up to a fiscal adjustment of nearly 10% of GDP, according to Moody's. In a presentation to investors in February, the government noted that it had already made cuts to its budget deficit worth 2.2 percentage points of GDP since the start of the year. For its part, Moody's is "relatively confident" that around 5% of Spain's proposed fiscal adjustment -- or half of the proposed cuts -- will "more or less" be achieved. "This is, in our view, a good start," the agency said.
Some aspects of Spain's policy proposals have been criticized, however. Most notably, the GDP growth projections built into its budget "look plainly optimistic given existing economic imbalances and the anticipated hit to domestic demand from higher taxes and lower spending," according to the Economist Intelligence Unit (EIU), a research firm. The government forecasts GDP growth of 1.8% in 2011; the EIU reckons 0.8% is more realistic.
Selling the public on sacrifices that are "extremely unpopular politically" is one of the biggest challenges Spain faces, notes Henisz. After all, the "best-case scenario is somewhere between five and 10 years of below-trend growth and above-average savings to pay off the debt overhang."
One of the key underlying problems is that all of the growth from the construction boom pushed up wages. "Low productivity growth in Spain relative to its competitors is what is really causing trouble right now," says Guillén. The only way for Spain to remain competitive is for the country "to increase productivity, because it cannot lower prices artificially through the exchange rate."
He adds that Spaniards will "see their standard of living come down as they restructure their economy. They will find a way in which they can compete globally." Over the next few years, there will be "a big readjustment, a big restructuring in Europe, and also in the United States ... as a result of the big changes that are taking place in the global economy."
Ireland down on its luck again this St. Patrick's Day
Ireland's economy offers little to celebrate this year on St. Patrick's Day. The Emerald Isle's output will likely decline for the third year in a row in 2010. And the national unemployment rate is still rising, approaching 13 percent. The brutal downturn has exacted a nasty toll on an economy that was hailed as Europe's "Celtic Tiger" before its housing and construction bubbles burst in 2007. Today's jobless rate of 12.7 percent is one of the highest in the European Union.
By some textbook economic definitions, Ireland's plight qualifies as a depression. After declining by 3 percent in 2008, Irish GDP plummeted 7.5 percent last year, and it will likely drop 1 percent in the first half of 2010, said Barry O'Leary, chief executive officer of Ireland's Investment and Development Agency, which seeks out foreign investment. Mr. O'Leary and most economists expect growth will return during the second half of this year. With exports totaling 90 percent of its GDP, Ireland's trade-dependent economy got clobbered by the global recession and the collapse of world trade.
The nation and its 4.2 million residents also suffered from massive corrections that followed the collapse of its overheated housing and construction markets, said Howard Archer, chief European economist for IHS Global Insight. Those corrections, in turn, severely weakened Ireland's banks. "Ireland was certainly one of the hardest hit of all the European economies, if not the hardest hit," Mr. Archer said. In several ways, Ireland set itself up for its big fall. As pay increases outpaced rises in productivity during the decade before the downturn hit, Ireland became less competitive.
Meanwhile, a decade of double-digit price rises in the housing market produced a huge bubble. Since peaking in early 2007, Irish housing prices have plunged about 30 percent, dragging down the banking sector in the process. The downturn has dramatically worsened Ireland's fiscal position, as its budget deficit soared to nearly 12 percent of GDP last year and will probably remain above 11 percent this year as GDP continues falling, Mr. O'Leary projected. But Mr. Archer also insists tough government measures mean that "the worst is over." "Ireland has taken very strong action to rein in its public finances," he said.
The government has slashed its spending and raised taxes. Since 2008, salaries of civil servants have fallen an average of 12 percent, Mr. O'Leary said. Raising personal income taxes on falling incomes has added further pain. Ireland has retained its relatively low corporate tax rate of 12.5 percent, which has been instrumental over the years in attracting so much foreign investment. Despite its woes, Ireland has done much more to regain competitiveness than other troubled European economies, including Greece and Portugal, said Scott MacDonald, the head of credit and economic research at Aladdin Capital Management, an asset manager.
Private-sector workers have absorbed wage cuts between 10 percent and 15 percent, "a very bitter bite for people," Mr. MacDonald said. "But there is not a culture of entitlement in Ireland like there is in Greece," he added. Ireland's economy will emerge from the downturn "structurally more sound than it was going in," predicted Mr. MacDonald, who is co-authoring a book titled "When Small Countries Crash."
As bad as the past three years have been, they will not come close to erasing the astonishing economic gains that the Irish have celebrated on St. Patrick's Day for decades. After averaging 4.5 percent during the first half of the 1990s, Ireland's annual growth rate accelerated to 9.5 percent during the second half of that decade, before "moderating" at 5.5 percent per year over the 2000-2007 period. Even with a double-digit jobless rate today, Mr. O'Leary noted that employment in Ireland is 64 percent above 1987 levels.
Social Immobility: Climbing The Economic Ladder Is Harder In The U.S. Than In Most European Countries
Is America the "land of opportunity"? Not so much. A new report from the Organization for Economic Co-Operation and Development (OECD) finds that social mobility between generations is dramatically lower in the U.S. than in many other developed countries. So if you want your children to climb the socioeconomic ladder higher than you did, move to Canada. The report finds the U.S. ranking well below Denmark, Australia, Norway, Finland, Canada, Sweden, Germany and Spain in terms of how freely citizens move up or down the social ladder. Only in Italy and Great Britain is the intensity of the relationship between individual and parental earnings even greater.
For instance, according to the OECD, 47 percent of the economic advantage that high-earning fathers in the United States have over low-earning fathers is transmitted to their sons, compare to, say, 17 percent in Australia and 19 percent in Canada. Recent economic events may be increasing social mobility in the U.S. -- but only of the downward variety. Harvard Professor Elizabeth Warren, for example, argues that America's middle class had been eroding for 30 years even before the massive blows caused by the financial crisis. And with unemployment currently at astronomical levels, if there are no jobs for young people leaving school, the result could be long-term underemployment and, effectively, a lost generation.
According to the OECD report, the main cause of social immobility is educational opportunity. It turns out that America's public school system, rather than lifting children up, is instead holding them down. One particularly effective way governments can help children from disadvantaged backgrounds improve their prospects, according to the report, is to increase the social mix within schools. Doing so "appears to boost performance of disadvantaged students without any apparent negative effects on overall performance." Early childhood education also helps a lot. Another big factor in social mobility is inequality, the report finds. The greater a nation's inequality, the harder it is for its children to improve their lot.
That confirms findings by other researchers. "The way I usually put this is that when the rungs of the ladder are far apart, it becomes more difficult to climb the ladder," Brookings Institution economist Isabel Sawhill tells HuffPost. "Given that we have more inequality in the U.S. right now than at any time since the 1920s, we should be concerned that this may become a vicious cycle. Inequality in one generation may mean less opportunity for the next generation to get ahead and thus still more inequality in the future." There are things governments can do to reduce inequality, the OECD points out. Progressive tax systems and social programs help reduce income inequalities between parents "so that their descendants' income would converge more quickly."
Perhaps more realistically for this country, given the current political climate, higher short-term unemployment benefits can reduce the effect of socioeconomic background on student achievement, the reports says. Gary Orfield, co-director of the Civil Rights Project/Proyecto Derechos Civiles at UCLA writes in an e-mail to HuffPost: "I think that researchers know about the poor mobility and millions of people are experiencing it -- but it is little discussed in a society in which both parties purport to represent the 'middle class' and no one is talking about the locked-in poor or the risk of downward mobility in public life."
As for the report's conclusions about the value of social mixing in schools, Orfield, a long time foe of school segregation, notes: "There has been such a relentless conservative attack on desegregation strategies, even those focusing on class,... that I think there has been very little discussion of peer group effects (except in college) for a long time. During that void, however, the research evidence has become much more powerful. "People need to understand that schools are basically students and teachers interacting together and that if you have classmates who know very little, you won't learn from them, you may be distracted by them. And teachers teaching entire classes and schools with students who are not ready to learn at their grade level and require all kinds of individual tutoring will often leave as soon [as] they can so these schools get the least experienced and qualified teachers, which perpetuates the inequality."
Just last month, Orfield's center issued a report urging President Obama, a supporter of charter schools, to take into account the extreme segregation of black students in those schools and to devise policies that encourage diversity.
All in all, the OECD report is an ugly reality check for a country that has historically seen itself as uniquely rewarding of talent; as a place free of the sorts of rigid social structures that led so many generations of immigrants to leave Old Europe. And the goal of reducing barriers to social mobility isn't just a moral imperative, it's an economic necessity, the OECD notes. "First, less mobile societies are more likely to waste or misallocate human skills and talents. Second, lack of equal opportunity may affect the motivation, effort and, ultimately, the productivity of citizens, with adverse effects on the overall efficiency and the growth potential of the economy."
Vallejo struggles to keep city safe during bankruptcy
It was just about two years ago that the city of Vallejo declared bankruptcy and started hacking away at its public services. Just last month, in the wake of heavy cuts to Vallejo’s police force, a wave of violent crimes gripped the town, leaving cities all over the Bay Area wondering what toll budget cuts can take.
What happens to a city when it’s reached the brink?
Reporter Adelaide Chen has this story.
ADELAIDE CHEN: On any given night, about ten police officers working the swing shift patrol the streets of Vallejo. On a recent Wednesday, one of them was Officer Drew Ramsey.
It was almost two years ago that Vallejo went broke. Literally. When it declared bankruptcy, it was the first ever for a California city of over 100,000 residents. At the time the police department had nearly 150 officers. Today Ramsey is one of a hundred--half of what you’d find in a Bay Area city with a similar size.
DREW RAMSEY: It’s not just the police department. The whole city has been affected by the bankruptcy. Everything gets cut. Our roads are not being paved when they should. Fire department is cut. Police department is cut. Schools are cut. Parks are cut. Just basically everything.
Ramsey says he hasn’t seen an increase in his paycheck since the bankruptcy. Luckily, there is one on the horizon, but not everyone is looking forward to it.
OSBY DAVIS: We only have so many dollars. And if they in fact take the pay raise it really only means we’re going to have to cut more in the police department because we don’t have the funds to continue to pay the raise and to maintain the staff.
That’s Vallejo Mayor Osby Davis, whose city budget has shrunk to a quarter of the size of neighboring city Fairfield, which has a smaller population by the way. Davis’s task is to steer Vallejo through its economic turmoil—a job that has increasingly been in the public eye since several violent crimes shook up his sleepy city.
Vallejo usually has about ten homicides a year. Last month alone there were three. But Mayor Davis says cuts to his police force are not to blame for the latest crime spree.
DAVIS: I don’t believe that the rash of crimes in the city of Vallejo had a direct correlation with the reduction of officers. That I believe firmly. And why? Because the types of crimes that occurred were sporadic crimes in different areas of the community. They’re not the kind of crimes that police officers, if you had enough, would be preventing anyway. You can’t prevent someone from sporadically shooting somebody.
Police officer Mat Mustard disagrees.
MAT MUSTARD: There’s a direct correlation between the 34% reduction in staff in the police department and what’s happened in relation to crime.
Mustard is president of Vallejo’s police officer union. His union sometimes gets blamed for Vallejo’s financial woes. After all, the police and fire departments account for over 70% of the current budget. But Mustard says his officers made concessions at the start of the bankruptcy.
MUSTARD: The police officer association went to the table and negotiated a deal in these tough economic times. And the police officers gave up almost 18% percent in salary reductions and benefit reductions. And, so, we’ve taken our haircut. We’re currently working way under our market in relationship to our salary and all we’re looking for is fairness.
MARC GARMAN: You got to look at total cost, not just the money, but wage and the benefits.
Marc Garman is editor of the online news site Vallejo Independent Bulletin. He usually supports unions, but he says that Vallejo’s union contracts have kept police salaries and benefits higher than those of other cities.
GARMAN: The total cost in Vallejo is about 12% higher than Richmond, for example.
Garman says Vallejo’s financial woes require everyone to take a cut. But police chief Bob Nichelini has said the officer’s union resisted further pay cuts. Here’s Chief Nichelini speaking last year at a city council meeting:
BOB NICHELINI: You know, we went into this, we met with the labor - the police association - and we said we want to lower our cost, like what was described earlier. And they said, No, no, cut the staff as much as you want, we want to be paid.
With the pensions, the payouts, the current salaries and benefits, the Bulletin’s Marc Garman says the city will have to cut more public safety jobs in order to balance its books.
GARMAN: And believe me, the wages that we see in Vallejo, it’s probably the last stand of these astronomical wages in my opinion, because other cities are on the verge. LA--they say they’ve got something like six months of money left. Vacaville’s feeling the squeeze. Napa’s scratching their heads. San Francisco’s going, my goodness, how are we going to survive?
Mayor Osby is already facing that financial reality. And he says the people of Vallejo need to come together to ensure a safe city.
OSBY: I’ve always believed and I still believe that policing the community is a community effort. You will never have enough police officers in your community. That is why it’s necessary to have the community step up and be willing to participate to make the community safe.
And in fact, citizens are stepping up in Vallejo.
Omar Martinez heads the county chapter of the Guardian Angels that has lately been patrolling Vallejo’s streets. He bursts in the door of a community meeting at a public library, grabs a microphone, and announces that the Guardian Angels just stopped a crime from happening near the library.
OMAR MARTINEZ: It was a robbery to begin with, but it could have turned into worse. Luckily my guys were here patrolling, which is again, what we do.
The mayor’s office didn’t pull this meeting together—the city has cut not just cops, but other public employees as well, which leaves the citizens to organize themselves.
Stephan Johnson is here with his nine-year-old son Elijah. He says the crime scene in Vallejo has gotten worse lately.
STEPHAN JOHNSON: My children are quite young so right now we don’t allow them to go out into public places by themselves, or ride their bikes in the streets or anything like that. We’re keeping them within the household.
Johnson and others in attendance are looking for solutions that neighborhood watch groups, churches, and non-profits can accomplish on their own. But what goes unspoken here is the elephant in the room. The question of whether, fundamentally, Vallejo just needs more money, money to put police on the streets.
JOHNSON: Most definitely, we do.
Vallejo is finding that there’s no such thing as a good backup plan when a city hits rock bottom. How do you keep safe, clean, and healthy when you’re bankrupt? Other Bay Area cities may soon be asking these questions too.
by Carley Dryden
As the burden of ever-increasing pension costs rests heavy on state and beach cities’ coffers, one question is on everyone’s minds — how will we pay for it?
CalPERS is bleeding. The economic meltdown of 2008 gouged a hole in the nation’s largest public pension fund, drying up the investments the California Public Employee Retirement System relies on to stay afloat. Local cities will be the bandage, shoring up millions in the next two years to help CalPERS recoup. Redondo Beach could cough up $24 million in the next two years for its retirees, while El Segundo faces layoffs and lower wages as it attempts to turn up more than $15 million. CalPERS saw its investment earnings peak at $260 billion in 2007 and plummet to $160 billion last March.
Critics have thrashed CalPERS actuaries for making poor investment decisions and unrealistic predictions on interest returns. Others have directed their fury to the public employees who are guaranteed more than $100,000 in retirement regardless of the market, while private sector employees wait on bended knee for their 401(k)s to be replenished. No matter which side of the political pension debate one falls on, few can question that the state has a serious pension problem.
The cost of state employee pensions grew by 2,000 percent in the last 10 years, while revenues increased by only 24 percent, Gov. Arnold Schwarzenegger said in his State of the State speech in January. "The pension fund will not have enough money to cover this amount, so the state — that means the taxpayer — has to come up with the rest of the money," he warned. "We are about to get run over by a locomotive. We can see the lights coming at us." The beach cities are hoping to stay away from the light, but are left with few options.
As CalPERS struggles to rebound from the sour economic market, its temporary solution will likely be dumping the burden on the backs of the local agencies who contract with it. More than 1.5 million California residents, including all of the beach cities’ municipal employees and elected officials, contract with and pay into CalPERS for their retirement benefits. CalPERS then invests the cities’ contributions, attempting to grow the funds so ideally the cities won’t have to give as much in the future. Legally, CalPERS is obligated to pay all enrolled retirees, even if the money isn’t there.
South Bay cities, already teetering under the weight of their own budget deficits, brace for the inevitable. "Like insurance companies, they balance bad investment returns on the backs of policy holders," said El Segundo Mayor Kelly McDowell. "They will place the burden on the cities." "Skyrocketing pension costs are a ticking time bomb," said Manhattan Beach City Councilman Wayne Powell.
Ticking time bomb
Why has the pension issue come to a head now? Pension experts blame a perfect storm of bold investments, improbable earning goals and the worst economic market since the Great Depression. In recent years, CalPERS moved its assets out of traditional stocks and bonds and into more alternative investments, namely real estate, hedge funds, and private and global equities, said pension expert James Hawley, professor and director of the Elfenworks Center for the Study of Fiduciary Capitalism at Saint Mary’s College of California.
Critics have sharply questioned CalPERS’ gravitation toward riskier investments. In 2008, the system lost nearly $1 billion after investing in a large tract of undeveloped residential property called Newhall Ranch, north of Los Angeles. Another $100 million invested in some East Palo Alto apartment conversion properties swirled down the drain after a drawn-out foreclosure fiasco. Overall in 2009, CalPERS saw a near 50-percent decline in real estate holdings. "In my mind, it’s piling on a huge amount of risk in a gamble to up the income," said Hawley of CalPERS’ alternative investment decisions.
For nearly a decade, CalPERs relied on nearly an 8-percent return on its investments of the local agencies’ money, which proved too lofty a goal when the market crashed in 2008. The system’s rate of return dropped 27.8 percent at the end of 2008. CalPERS expects investment earnings to cover 75 percent of its obligations, with the rest on the shoulders of government employers and employees. So with CalPERS’ recovery expected to be years away, what does that mean for the beach cities? Increased contributions to the retirement system.
With the cities already sending CalPERS more money than most (rates are based on employee salaries), even a small increase could lead to a reduced level of city services. Through collective bargaining agreements, the beach cities provide their employees a "defined benefit" retirement plan, in which the cities cover the employees’ contributions to CalPERS, on top of paying the employer’s expected contributions annually. Ten years ago, when times were good, CalPERS had an influx of investment earnings. "They had made so much money off the money we sent them, they were super funded," said Manhattan Beach Finance Director Bruce Moe. The cities were able to stop contributing since their excess was pooled in CalPERS’ coffers.
But CalPERS is as much a pension fund as a marketing organization, Moe said. Reminding agencies that they had superfluous funds sitting unused in Sacramento, the system encouraged cities to sign their employees up for enhanced benefit plans, which allowed them to earn more at a younger retirement age. The cities signed up for the plans thinking their contribution rates wouldn’t change, said David Biggs, assistant city manager in Redondo Beach. But they did, increasing between 10 percent to 20 percent. "The cities should have continued to make contributions. The market’s never going to only be positive," Biggs said.
Now, the market’s foundered, but cities are still expected to cover the generous benefit plans they upgraded to when times flourished. Most of the beach cities’ employees can receive 90 percent of their final year’s salary annually in retirement after 30 years of service in a CalPERs agency. Some make more than $100,000 in retirement. The plan also allows a rare few to make more than 100 percent of their salary in retirement. While criticism and blame run rampant, solutions to the pension problem are scarce.
Local agencies, like many across the state, are relying on state pension reform through initiatives like one proposed by the California Foundation for Fiscal Responsibility that would lower pension costs by capping pension payouts and increasing the retirement age. But experts say cities can’t wait. A study on the country’s pension crisis released by The Pew Center on the States in February showed that states would be forced to reduce benefits, raise taxes or cut government services to address a $1 trillion funding shortfall in public sector retirement benefits.
According to the study, if immediate solutions aren’t initiated, like an increased retirement age or move toward more employee contributions, some states will face "high annual costs that come with significant unfunded liabilities, lower bond ratings, less money available for services, higher taxes and the specter of worsening problems in the future." Even CalPERS itself, in the form of Chief Actuary Ron Seeling, declared that the system faces decades of "unsustainable" pension costs. So unless local cities bow out of CalPERS and choose another agency to manage their employees’ retirement benefits, sustainable solutions must be found to combat a shaky CalPERS future.
Cities brace for impact
Manhattan Beach contributed $5.1 million of its $50 million budget to CalPERS in 2009-10. Next year, the city will likely have to contribute an additional $1 million, while also battling a $2.5 million general fund deficit. "The stuff hits the fan next year," Moe said. "(One million dollars) is a huge budget hit for us," he said. Currently, the city pays 29.7 percent of the funds allotted for police salaries to police pension contributions, 27.27 percent of the total fire salaries to the fire pensions and 14 percent of the Miscellaneous/Teamsters salaries. Those totals include the employee contribution rates of 9 percent for safety and 7 percent for miscellaneous.
Manhattan Beach employees (like the employees of the other beach cities with some variations) fall under one of four categories: the police officers association union; the firefighters association union; the Teamsters or Miscellaneous union; and those in the nonunion management confidential unit, which includes mostly department heads. The management group members receive the same benefits as the group they supervise, Moe said. The police chief receives the same benefits as the police officers, the fire chief the same benefits as the firefighters and so on. All employees and City Council members qualify for CalPERS after serving the city for five years.
Powell, Councilman Richard Montgomery and Councilwoman Portia Cohen all said the city will have to consider switching to a two-tiered retirement system. In a two-tiered plan, new hires would contribute more to their pension, a "defined contribution" plan more like a 401(k), which has become mostly universal in the private sector. Cohen said the City Council should also consider increasing the retirement age, lengthening the vesting period for pension and medical benefits, reimbursing instead of cashing out salary "add-ons" for education and uniforms, and re-evaluating "longevity pay" and final year promotions that increase the city’s retirement liabilities.
"It’s only fair to ask city employees to make some compromises rather than to have to significantly cut city services and programs, especially when our residents are making sacrifices in the private sector," Powell said. City employees will have to change their expectations, Montgomery said, and pay raises may be nonexistent in coming years. "The sympathy days are over. We’re not trying to be unfair. It’s not fair to give (them) that concession. It’s not fair to us," he said. If adjustments aren’t made in the union contracts, jobs will be lost, Montgomery said. "If they want to fight for a 1 percent or 2 percent increase, then I have to lay people off. It’s not fair to take all of my cuts from Parks and Rec or Public Works if police and fire won’t take any cuts," he said. "We have to spread the pain through all divisions."
While the city can decide to renegotiate with the unions to ask for employee contributions, the employee contribution rate is capped at 9 percent for safety and 7 percent for miscellaneous according to state law, Moe said. The city does not have to wait for the union contracts to expire to renegotiate with the unions, if the union representatives agree, Moe said. But the unions do have a legal right to wait until their contract expires to make changes to their contracts, Moe said. The city’s firefighters association contract expires July 31, 2010. The police officers association and miscellaneous contracts expire in the summer of 2011.
Hermosa Beach spent just more than 12 percent of its total operating budget, or $4.1 million, on pension costs this year. Nearly 40 percent of the total funds allotted for fire salaries and nearly 50 percent of the police salary funds were contributed to CalPERS for the safety groups’ pensions this year. Nearly 15 percent of the miscellaneous salaries were contributed for miscellaneous pensions. The city’s total contribution to CalPERS will increase by nearly $600,000 in 2010-11 and by close to $300,000 more in 2011-12, said Finance Director Viki Copeland. Since all of the city’s union contracts expire this June 30, the city has the opportunity to renegotiate employee benefits in the next few months.
Copeland said the City Council has discussed requiring employees to contribute more to their retirement plan and basing their annual pensions on an average of their three final years rather than the single highest year’s salary. Mayor Michael DiVirgilio said the City Council directed the city manager to develop a proposal for a two-tier retirement system that would offer a lower-cost plan to new city employees. "The City Council is also looking at other options to reduce the retirement costs, and these options are being developed now and will also be the subject of discussions with our labor organizations," DiVirgilio said. When asked his thoughts on the CalPERS issue, Councilman Howard Fishman replied that DiVirgilio’s comments represent the entire council’s positions. None of the other Hermosa Beach council members responded.
Redondo Beach contributed nearly $11 million, 11 percent of its total budget, to CalPERS on behalf of its employees this year. The city will see that contribution rise by $100,000 to $300,000 next year, and between $1 million and $1.5 million in 2011-12. Currently, the city pays 32 percent of the funds allotted for safety salaries for police and fire pensions, and 11 percent of the miscellaneous funds to that group’s pension contributions.
"Like paying farmers not to plant crops, we are paying people not to work," said Councilman Steve Diels. "General fund monies that go to retirees are not available to pay our active workforce. Ultimately, the taxpayers, wage earners and businesses suffer." While Biggs and Diels agree that solutions must be in place to address potential shortfalls, the city has yet to publicly announce any specific game plans. Biggs said the city won’t start discussions with the labor groups until the city staff gets a better handle on next year’s budget. The city is likely still wary to start finagling concessions out of the unions, considering all Redondo Beach employees took a 6-percent pay cut and suspended a 4-percent cost of living increase to avoid layoffs last year.
"Could we ask them to pay more? Yes. Will we? That’s a possibility. But it’s hard to come behind a 10-percent pay cut and say: ‘By the way, we need an additional 5 percent contribution to CalPERS.’ It’s going to be a real tough sell," said Redondo Councilman Pat Aust. Aust sees light at the end of the tunnel. He has spent more than 40 years working for the city of Redondo and is the highest-paid pensioner in the city. He’s seen the pension hysteria settle onto cities in cycles. CalPERS will never go broke, he said, unless cities declare bankruptcy and stop paying into it. "They’ll never be in the hole. It’s a dynamo. It will run on itself as long as we’re paying the money," he said.
Aust said CalPERS will simply rely on the cities to make up their deficits time and time again. "I understand this is a bad time and changes will have to be made to get past it … It isn’t the Titanic. The ship isn’t going to sink and everybody drowns. Council members are in hysteria, ‘The sky is falling!’" he said. "I’m not ready to panic." Aust said the market will go back up eventually. "It is a tough time, but it’s not the only tough time I’ve seen," he said.
Kelly McDowell is a straight-shooter. The El Segundo mayor knows his city has a pension problem — a $7.5 million problem. That was the city’s contribution to CalPERS for this year. "The costs are getting out of control," he said. Over the next two years, that number will rise another 6 percent to 8 percent. "Unless we find a way to meet the costs, which are not coming down, the level of service has to go down. It’s that simple," he said. With the city already facing a cumulative $40 million deficit over the next five years, the increased CalPERS burden will mean dramatic changes, he said. McDowell said the city cut every nickel it could to avoid layoffs while lowering a $7 million budget deficit this year. "Next year we’re looking at almost a $9 million deficit … We can’t do it any longer without layoffs," he said.
Each of the city’s six bargaining groups is being asked to give back some of their compensation, McDowell said, "with the alternative being layoffs." The Teamsters contract expires this summer, while the safety contracts don’t expire until September 2011. The city will also consider placing new hires on a reduced pay scale and retirement plan. McDowell said the unions and residents have to be realistic about the future. "If citizens demand the same level of service, it’s going to be more expensive," he said. "If they are satisfied with a lower level of service, that’s what you’re going to get by trying to hold on to the current structure." McDowell said residents, already paying high taxes, want and deserve the highest level of service.
Since increased taxation likely wouldn’t make it through the voting process, he said, the city will have to come up with other options. The city is in discussion with L.A. County to outsource Fire Department services, which could save $4 million to $8 million a year, he said. "Something pretty dramatic is going to have to change," he said.
Any real solutions?
Redondo Beach’s Diels said the cities are facing more than an economic cycle, but a tectonic shift. "We live in the age where past practices have caught up with us. New thinking and new solutions are necessary to navigate the new reality," he said. But will the solutions being considered solve the problem of today? Even if cities enact a two-tier retirement plan, it could take several years to see a decline in pension costs since the city would have to wait for new hires to come in. "It could take 10 years or more before you saw any benefit," Biggs said. Hawley said he doesn’t think a shift toward defined contribution plans in the public sector solves the problem.
"It may from the point of view of the city or county. They don’t have the liability," he said. "The point of a retirement system is so people can retire at some reasonable middle-class standard of living." With the volatility of the markets, it’s a real gamble for average income earners, he said. Though some retirees in each of the beach cities are making more than $100,000 a year in retirement, the average retirement benefit for employees is much lower. In Manhattan Beach for example, the average retirement payout for police is $29,000 and for fire, about $30,000. The average miscellaneous retirement payout is $11,000, according to CalPERS. "You’re essentially transferring liabilities to lower-income people," Hawley said. "If you look at what defined contribution plans actually produce, you can’t retire on that."
Other solutions — like changing the terms and intricacies of benefit plans — would require state reform, and one proposed pension initiative for November has already stalled due to lack of support. The beach cities face tough choices during the upcoming months of renegotiations and the budgeting process. "I know there are no painless solutions," McDowell said. "There may be none that are less than exceedingly painful. It will require a lot of inventiveness on the part of all stakeholders to still maintain a level of service that the public will accept." Said McDowell: "It’s unfortunately bleak out there."
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