Thursday, July 28, 2011

July 28 2011: Real Black. Real Swan.

Detroit Publishing Co. Surf bathing 1905
"Splashing around in the ocean -- the latest fad. Coney Island, New York"

Ilargi: Perhaps the best way to distinguish a black swan event from a run of the mill incident is to ask yourself if your favorite fiction writer could have invented the scenario involved, and remained believable. If the answer is yes, obviously it's not a black swan.

The recent accident -and its consequences- at the Vasilikos power station on the Mediterranean island(-state) of Cyprus, forever torn between its Greek and it Turkish parts, would certainly seem to meet this definition of a black swan event.

Vasilikos is the newest power station on Cyprus, which joined the EU in 2004 and adopted the Euro in 2008. The station is primarily powered by steam generated by heavy fuel oil, with some gas turbines. Though operating, it was still partly under construction when the accident happened.

At 05:50 EEST (02:50 UTC), on July 11, 2011, there was a huge explosion at the nearby Evangelos Florakis Naval Base. Wikipedia describes just how black this swan is:
In open storage on the base were 98 containers of explosives that had been seized by the United States Navy in 2009 after it intercepted a Cypriot-flagged, Russian owned vessel, the MV Monchegorsk, travelling from Iran to Syria in the Red Sea. According to leaked US cables through WikiLeaks, released in 2011, the US through Hillary Clinton exerted pressure on Cyprus to confiscate the shipment.

The ship was escorted to a Cypriot port and the Cyprus Navy was given responsibility for the explosives, which it moved to the Evangelos Florakis a month later.[9] At the time of the incident in 2011, the explosives had apparently been left in the open for over two years.

The Cypriot government had declined offers from Germany, the United Kingdom and the United States to remove or dispose of the material, having feared an adverse reaction from Syria. The government had instead requested that the UN effect the removal, but claimed that its request had been rejected.

Tell me, which writer can make that up and live? Iranian munitions destined for Syria on board a Russian vessel under a Cypriot flag, confiscated under American pressure and dragged al the way from the Red Sea to Cyprus. And that are then stored in the open for two years in sometimes high temperatures (40C, or 104F, right now), because nobody wants to touch them. And then proceed to blow up the country's main power station.

The explosion killed 13 people and wounded over 60. The official cause given is self-detonation of the munitions, according to Wikipedia. Hard to gauge how reliable that is.

While large parts of the over 800,000 strong Cypriot population, as well as its business community and -particularly important- tourism industry, are now subject to (rolling) blackouts, the Vasilikos damage may, according to estimates, take two years and €2.4 billion to repair. The €2.4 billion constitutes about 14% of Cyprus €17 billion ($23.8 billion) annual GDP.

Cyprus was already under financial scrutiny, for a number of reasons. First, Its banking system is "roughly nine times GDP". Second, that system is relatively heavily (33% of GDP) invested in Greek sovereign debt, and has also lent out a lot of money to Greek businesses and individuals. And third, a lot of the foreign deposits flowing in are from Russia, which uses the island as a gateway to Europe.

Just yesterday, under intense pressure from the people, who want anyone even remotely responsible for the explosion out, the Cypriot government, led by the Communist party, and already unpopular before the incident because of -what else?- austerity measures, resigned.

This happened not along after Moody's downgraded Cyprus bonds, which were already under pressure due to the Greek debt holdings, and are now vying for par with Irish and Portuguese bonds. And rising.

After Ireland, Greece (2x) and Portugal, Cyprus is therefore set to become the fourth EU member to need a bail-out. It's small one, for sure, but it might still whip up resistance against the EU/ECB/IMF troika policies well beyond its size.

And it took a black swan to push it over the edge, one in which energy and finance combine in a realistic way, none of that silly 'peak oil leads to peak debt' stuff, and one that paints in glaring detail where the vulnerabilities of our societies may lie. That is to say, where we least expect them.

MEANWHILE, Stateside:

At 6.00 PM EDT there is a vote on the Republican debt ceiling plan. It will lose, either in the House or subsequently in the Senate. There will then be about 100 hours left before the August 2 deadline, which may or may not be an actual deadline. An agreement, of course, will be reached at the eleventh hour. After which, much media posturing will take place, and if Europe is awake it can use the opportunity to further sink the euro and take a nice lead in the currency race to the bottom. Mind you, if someone figures out a good reason why August 2 should not be seen as crunch time, Washington can play this game for as long as it pleases. That is, unless the rating agencies tell it to stop. Looking at who's candidate to really be in control here, it might as well be Moody's. What's the difference? Still, even that wouldn't make it a black swan. No grace whatsoever.

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If US Defaults, Stocks Fall 30%, GDP 5%: Credit Suisse
by Patrick Allen - CNBC

In the very unlikely event that the United States defaults on its debt obligations, the country's economy would contract by 5 percent and stocks would fall by nearly a third, according to Credit Suisse.

While Andrew Garthwaite and the global strategy team at the Swiss bank see a 50-50 chance of a ratings downgrade of U.S. debt by the major ratings agencies, they remain confident such an outcome would not lead to disaster. "We think there is a 50 percent chance of a ratings downgrade on U.S. sovereign debt.

This could happen even if the debt ceiling is raised," Garthwaite, the head of global strategy at Credit Suisse, said in research note. "We doubt it will have much effect," he continued. "Japan has a 1.1 percent yield and an AA- rating, many U.S. Treasury funds do not have credit-rating limitations and national bank regulators would probably keep risk weightings for U.S. sovereign debt at zero."

If no budget deal is struck, but the U.S. does not default, Garthwaite predicts a bad time for stocks and the economy. "As our economists point out, each month of no rise in the ceiling could easily take 0.5-1 percent off GDP. In this case, equity markets would drop by 10-15 percent, prompting Congress to find a solution, and bond yields would fall to 2.75 percent." If that proved to be the case, investors would in Garthwaite’s opinion need to get into defensive stocks and out of the dollar.

However, the worst case scenario is clearly an outright U.S. default. That is where things could get nasty, according to the Credit Suisse team. "This is very unlikely, but if it occurs, GDP could fall 5 percent plus, and equities by 30 percent," Garthwaite said.

In the event of such a disastrous outcome, Garthwaite predicts the only place to hide would be in cash-rich stocks. "Worries about the U.S. public finances will likely bring investors to focus on ultra-safe equities: companies with [credit default swap] spreads below that of G7 sovereigns, yet offering dividend yields above government bond yields: Centrica, Sanofi, Novartis, Compass, Pfizer, Merck." With fiscal tightening in the cards no matter what the outcome of talks in Washington, Garthwaite is worried about the effect on growth, but not that worried.

"Our main concern is that, on IMF estimates, fiscal tightening in the U.S. will be equivalent to nearly 2.5 percent of GDP next year." Garthwaite’s economics team predicts that most of that tightening estimated by the International Monetary Fund will not actually take place, and predicts only half a percent of GDP growth being lost as result.

Bank chiefs send US debt default warning
by Tom Braithwaite, Michael Mackenzie and Robin Harding - FT

Wall Street’s leading chief executives intervened in the US debt debate on Thursday, writing to President Barack Obama and Congress to warn of "very grave" consequences of a default and urging them to cut a deal "this week".

Lloyd Blankfein of Goldman Sachs and Jamie Dimon of JPMorgan Chase were among 14 chief executives of banks and insurers who signed the letter, along with Rob Nichols, the head of the Financial Services Forum, the umbrella association for the biggest financial groups in the US.

The letter said a default, which is still perceived as unlikely, or a downgrade from triple A, which analysts believe is increasingly likely, "would be a tremendous blow to business and investor confidence – raising interest rates for everyone who borrows, undermining the value of the dollar, and roiling stock and bond markets".

It comes after bankers, from senior executives to traders, have been becoming frustrated that the Federal Reserve is refusing to engage in scenario planning for a US downgrade or default.

With days until the Treasury’s August 2 deadline to raise the debt ceiling, bankers said they were not getting a response to efforts to discuss the market impact of a failure to reach a deal in Washington or if credit ratings agencies cut the US triple A rating.

They want to address contingency planning for a run on money market funds that hold Treasury bonds, the impact on capital and liquidity ratios if there are large inflows or outflows of deposits and the potential effect on short-term financing from any problems in the repurchase, or "repo", market.

"The responsible government people aren’t engaging and I bet a piece of it is they are really not sure what to do," said one person on the industry side. Another said: "We don’t have any information from them. For the government shutdown [when budget disagreements nearly closed down the federal government] at least we had a road map."

The Fed is in the complicated situation of being both the principal regulator of the financial system and the agent of the US government, with responsibility to pay the Treasury’s cheques, process its electronic payments and issue, transfer and redeem Treasury securities.

"In these matters, the Federal Reserve serves as the fiscal agent of the US government. As such, we have been engaged in operational planning with the Treasury," the Fed said. "We expect to be able to give additional guidance to financial institutions when there is greater clarity from the Congress and as Treasury details its specific plans."

As Republicans and Democrats in Congress revised competing plans to avert a crisis, investors have grown more pessimistic over a debt ceiling deal that can deliver large, long-term spending cuts and prevent the US form losing its triple A rating. "The equity market’s sell-off is clearly a reaction to the intractability of Congress and the president," said Jack Ablin, chief investment officer at Harris Private Bank. "It’s clearly frustrating investors worldwide but is ultimately a buying opportunity as this is a contrived crisis." In contrast to the slide in equities, the dollar pared its losses and the euro dropped 1 per cent. Bond yelds rose modestly.

Market participants said the Fed and the Treasury had been engaging with dealers as they usually do to monitor market flows and liquidity but had stopped short of any scenario planning. The Treasury has so far refused to make public any contingency plans for the event that there is no rise in the debt ceiling. Unless the Treasury says, for example, whether it would prioritise interest payments, then it is hard for the Fed to discuss the implications with banks.

Bankers also believe that the Fed is afraid of sending signals that it is gearing up for a downgrade or, a scenario most analysts still consider remote, a technical default. In contrast, the International Swaps and Derivatives Association on Wednesday published information regarding the settlement of credit default swaps on US debt in the event that there are missed payments.

Banks are concerned about a wide range of operational issues as well as the broader question of how the Fed would support the financial system if there were disruption caused by a failure to raise the debt ceiling.

For example, they would like to know whether the Fed would be willing to lend against Treasuries with a defaulted interest payment, which would support the repo market. At a broader level, they would like to know whether the Fed will support the refinancing of Treasury securities by stepping in and buying any unsold stock at auctions.

In terms of the overall financial system, banks want to know what support the Fed would offer if there were a run on money market funds – knowing the Fed will provide them liquidity would reduce the chance of such a run.

They also want to know how the Fed would handle their capital and liquidity regulation if, for example, Treasuries fell in value or they experienced large inflows or outflows of deposits and how principal and interest payments would be made.

Flee to Mars if America commits worst error since 1931
by Ambrose Evans-Pritchard - Telegraph

President Obama has categorically ruled out a constitutional challenge to the US debt ceiling since I wrote yesterday’s blog. Spokesman Jay Carney said the White House cannot invoke the 14th Amendment, which stipulates that US federal debt "shall not be questioned".

"It’s not available. The Constitution makes clear that Congress has the authority, not the president, to borrow money and only Congress can increase the statutory debt ceiling. That is just a reality," he said. That is questionable, but let us move on.

Obama had previously been vague about this, saying White House lawyers were "not persuaded that is a winning argument". It is a revealing turn of phrase. This is indeed about winning arguments, not abiding by constitutional law. It is understandable why he should wish to avoid to an end-run around Congress in this violently polarized atmosphere, though it would not have stopped have FDR. (He went much further by stacking the Supreme Court).

However, the 14th Amendment still binds the nation. The US cannot miss a coupon payment on past debt without breaching the nation’s highest law, and without defiling the honour of the United States. So this shifts the balance of probabilities a little further towards a brutal fiscal shock as spending is cut to meet the debt ceiling, if Congressional leaders fail to marshal their troops in any semblance of order over coming days.

Since tax revenues cover just 60pc of the federal budget, the squeeze would have to be on a scale large enough within a few months to tip the US economy into a downward spiral and take the world with it. As an historic policy error it would match the New York Fed’s decision to raise interest rates twice in one week in October 1931, but at least the Fed had an excuse. (The Banque de France had withdrawn gold reserves from the US).

Mr Obama might conceivably calculate that mass furloughs or Social Security cuts or whatever shape austerity might take would do more damage to the Republicans than to the White House. It seems an unlikely hypothesis to me. I leave it to American readers to debate who would come out of this in worst shape. I adamantly refuse to take sides in this dispute. Both parties have brought America to this unhappy pass over the last 50 years. A plague on both their houses.

Should America embark on such fiscal contraction at a time when economic growth has already slipped to stall speed, and debt deleveraging continues with a vengeance, I would like to flee to Mars for safety.

Yes, there is such a concept as an "expansionary fiscal contraction", as in Ireland (1980s), Denmark (1990s), arguably Canada (1990s), and the UK after both 1932 and 1993, but in every successful case this was accompanied by monetary loosening. That card has already been played this time.

Should America instead opt to evade these fiscal cuts by actually defaulting on debts accumulated by self-indulgent baby boomers, I would also like to flee Mars because such an outcome might be even worse.

Those who choose to breach America’s sacred bond to creditors across the world in this squalid way, in circumstances short of war or extenuating distress, deserve our contempt. Be they accursed forever if they stoop so low.

As for America’s loss of its AAA rating, a number of readers strongly disagree with my view that this would be a one-day drama, arguing that great numbers of bondholders would be forced to sell their debt under investment rules.

I do not find that sort of mechanical argument to be convincing. You can change those sorts of rules in a heartbeat, just as the ECB tweaked its collateral rules for Greece when it needed to, or Japan softened regulations after its downgrades. The AAA debate is a distraction.

The Bonds of August
by Menzie Chinn - Econbrowser

An Historical Analogy applied to today's debt ceiling crisis, with apologies to Barbara Tuchman

Discerning readers of history (so that excludes a number of people) will recall that in Tuchman’s magisterial account of how the world went to war in August 1914, she identified several factors that accounted for why the leaders of the great powers each felt victory would be painless assured. First, they thought that the war would be quick; "Home before the leaves fall", as Kaiser Wilhelm predicted. Second, they broadly misunderstood the economic implications of the conflict, believing free trade would prevent an expansion of the conflict to continent-wide proportions. Third, military leaders failed to consider the political implications of military plans, such as the German violation of Belgian neutrality.

The result was a costly and prolonged war that no leader sought, or even contemplated, but were pushed into exactly because of their mistaken beliefs.

I think we could very much be in for a repeat of this experience. Even if there are extraordinary measures are implemented which extend the X-date beyond August 2nd, the very fact that the Republicans have no viable plan, given the veto held by the Tea Party component [0], for achieving some sort of compromise indicates that we are inexorably moving to some sort of crisis.

Consider the following:
  • Certain individuals believe the debt default would be temporary (or "technical"), lasting until the politicians come to their senses (Pawlenty, Ryan) [1] or can be avoided by selectively defaulting on only non-debt payments (Bachmann, Gohmert) [2]
  • Certain individuals think the effects of the default would be short lived and minimal.
  • Certain individuals think that the rest of the world (including holders of US Treasurys, like PBoC) will not react to a default, and the policy paralysis evidenced by this event. [3]

My analogy is not completely apt in one important sense. The delusions are almost completely held on one side. As long as these delusional individuals hold veto power in the policy process, we are doomed to some sort of event; perhaps it will take a EESA redux -- with trillions of dollars of equity value wiped out, and municipal bonds being eviscerated [4] -- to make them realize that this is not a game.

By the way, even if the Administration is able to extend funding capacity beyond August 2nd, the one thing those who have studied currency crises in emerging markets know is that -- given rational expectations -- the crisis typically occurs before the exhaustion of reserves (Krugman, P. (1979) "A model of balance of payments crises", JMCB 11: 311-325.) There is some evidence of this wariness already. [5] Of course, as international finance economists we typically thought of first-generation currency crises as a problem restricted to emerging markets and less developed economies. Little did Jeff Frieden and I know that when we entitled the first chapter of our forthcoming book, Lost Decades, "Welcome to Argentina", how apt that title would become in describing policy making as well as policy problems. That policy paralysis due to ideology is something financial market participants have also noted.

For those who think a 4 to 1 ratio of spending cuts to tax increases is still too much tax increase, and believe all adjustment can be done by spending cuts alone, I bring their attention to the following graph of spending and revenues.


Figure 1: Federal current expenditures, line 20, BEA Table 3.2 (red) and sum of Federal tax receipts and social program contributions, lines 2 and 11, BEA Table 3.2, both divided by GDP. All raw figures in billions of $, SAAR. NBER defined recession dates shaded gray. Dashed lines at 2001Q1 and 2009Q1. Source: BEA, 2011Q1 3rd release, NBER, and author’s calculations.

So what will the impact of a default be? The IMF reminds us that, just like WW I did not remain contained to a few countries, the fallout from a US default is likely to global in nature (from Reuters):
An IMF official, briefing reporters by telephone, said that if the United States' AAA debt rating -- regarded as the gold standard for creditworthiness -- was downgraded it could be "extremely damaging" for the U.S. and world economy.

The IMF official said that, since such a downgrade would be precedent-setting, it was impossible to predict with certainty the impact, but it would certainly drive interest rates up.

While underlining the urgency of reaching a debt-reducing agreement, the IMF also cautioned that an "excessively large upfront fiscal adjustment" should be avoided because that would further dampen domestic demand and slow growth.

"With a still-wide output gap and downside risks to the outlook, especially potential spillovers from European financial markets, directors called for a cautious approach to unwinding macroeconomic support," the IMF said.

For another analogy, see Jeff Frankel's interpretation of the game now going on.

Finally, a bad omen (USAToday):
"The markets are pricing in a strong likelihood of no default and no government shutdown," says Don Luskin, chief investment officer at TrendMacro.

This is the same Don Luskin who wrote on September 18, 2008, that "we're on the brink not of recession, but of accelerating prosperity." In the next quarter, real GDP fell 6.74% (SAAR). I'll take the "Don Luskin indicator" to suggest we are hurtling toward a very serious situation.

It's not the default, it's the downgrade
by Carrie Budoff Brown and Ben White - Politico

It’s not the default that strikes the most fear in the White House and Congress these days. It’s the downgrade.

Even Republican leaders say the country can’t go into default, and they’ll do everything possible to raise the debt limit by Aug. 2. But what really haunts the administration is the very real prospect, stoked two weeks ago by Standard & Poor’s, that Barack Obama could go down in history as the president who presided over his country’s loss of its gold-plated, triple-A bond rating.

Obama could win and lose at the same time, striking a deal to avoid default but failing to pass muster on the substance of that deal with credit agencies, which could go ahead and downgrade the rating anyway.

Financial analysts say such a move would hit Americans with more than $100 billion a year in higher borrowing costs, but it’s not just that. It would be a psychic blow to a nation that already looks over its shoulder at rising economic powers like China and wonders, what’s gone wrong? And it would give the president’s Republican rivals a ready-made line of attack that he’s dragging the country in the wrong direction.

It’s what drives his Treasury Department into cajoling and pleading with the bond ratings agencies to be patient, like a harried coach working the refs from the sidelines. It’s a factor influencing Obama’s rejection of a short-term deal: The administration believes the ratings agencies won’t like it.

And it’s what gives these little-known firms a powerful club that they’re wielding with gusto over Washington policy-makers. They hope to force a deal that not only raises the debt ceiling but also makes deep cuts in government spending and eats into the nation’s deficit.

The threat of a downgrade "is very damaging to all of us, and that would be a product of the dysfunction of Congress" said Rep. Peter Welch (D-Vt.), who led a faction of House Democrats who argued for a "clean" debt-limit increase early in the process, only to watch escalating chatter about the "Armageddon" of a missed deal feed scrutiny of the nation’s fiscal health.

S&P raised the threat of a downgrade July 14 by declaring that raising the debt limit alone might not be enough. It wanted to see an enforceable agreement to cut $4 trillion over 10 years to affirm the triple-A rating.

Administration officials were shocked by the move. They suggested privately that it did not seem to square with prior S&P reports, which said the nation’s larger budget problems could be dealt with over several years. Some administration officials dismissed the S&P report as little more than amateur political prognostication by people with limited understanding of how Washington works.

But the White House’s statements in the past week show a downgrade is now top of mind. Obama himself invoked the country’s triple-A rating in a rare prime-time address Monday as he outlined the consequences of default.

"For the first time in history, our country’s triple-A credit rating would be downgraded, leaving investors around the world to wonder whether the United States is still a good bet," Obama said. "Interest rates would skyrocket on credit cards, on mortgages and on car loans, which amounts to a huge tax hike on the American people. We would risk sparking a deep economic crisis — this one caused almost entirely by Washington."

Nearly every debt-limit conversation on Capitol Hill is infused with debate over the potential for either a downgrade, a default, or both. Democrats have embraced the argument of the White House: A short-term plan could result in a debilitating downgrade even if default is avoided.

Republicans are moving forward with their two-phase plan, but they’ve shown some concern about the possibility of ratings agencies scarring America’s creditworthiness. There’s significant disagreement in the GOP about the prospects of default and downgrade, and some lawmakers believe the administration and congressional leaders have created a false panic to box them into voting to raise the debt ceiling.

"The reality is these rating agencies have no idea how to rate a $17 trillion economy like the United States," Rep. Darrell Issa (R-Calif.) told radio host Don Imus on Monday. "They have no idea how to rate the debt worthiness of a $14 trillion debt like the United States."

The truth is that Capitol Hill has less insight into the workings of the marketplace than the investment gurus on Wall Street, and even they have varying views on the potential for a downgrade. There is also no clear sense of how the ratings agencies would ultimately judge the two major plans in the mix.

The Senate Democratic proposal calls for a one-time increase in the debt limit through the 2012 elections coupled with $1.7 trillion in spending cuts and about $1 trillion in savings from winding down the Iraq and Afghanistan wars. The House Republican bill would raise the debt limit in two phases and mandate a deficit cut of $3 trillion.

But the second debt limit increase next year would depend on Congress adopting the recommendations of new 12-member legislative committee for $1.8 trillion in cuts — far from certain, given the polarized political environment. That lack of certainty could raise concerns with the ratings agencies, Democrats said.

Aiming for any ounce of advantage, Senate Majority Leader Harry Reid (D-Nev.) argued Tuesday that his plan would shield the country from a ratings drop, while Boehner’s plan would not — a statement Boehner’s office contested.

"The $3 trillion House plan is the only one on the table that forces Congress to take on the drivers of our debt," said Boehner spokesman Brendan Buck, adding that the Reid plan relies on war savings, "an accounting gimmick that will have zero real-world impact on our deficit."

On a Tuesday conference call with reporters, bank analysts predicted the odds of a default are close to zero, but warned that a downgrade is a growing possibility. An agreement that sustains a top-notch rating would have to include $3 trillion to $4 trillion in budget deficit cuts over the next decade, said Terry Belton, global head of fixed income strategy at JPMorgan Chase.

Not just that, said Mike Hanson, senior U.S. economist at Bank of America Merrill Lynch, but credit agencies also want the ultimate plan to have strong bipartisan backing. "It really is important that we need to have a deal that is fairly comprehensive and has fairly broad support," Hanson stressed.

A single downgrade might have limited market impact. But a move by all three main ratings agencies — S&P, Moody’s Investor Service and Fitch Ratings — would likely force huge investment funds that must hold only the safest of bonds to sell en masse. The scary headlines associated with a first-in-history downgrade also could cause smaller investors to panic and dump stocks.

In a recent interview with POLITICO, David T. Beers, head of sovereign ratings at S&P, said the July 14th report was not a major shift and simply reflected an increased concern that there is no clear path to significant deficit reduction. "What we are focused on is not the debt ceiling but the underlying state of public finances," said Beers, a London-based executive who has conducted multiple meetings with administration officials.

In order to maintain a triple-A rating, Beers said, "what would have to emerge would be something that has a material impact on the underlying fiscal issues." "None of us know what this agreement is going to look like," Beers said. "For us to think it is credible it would first of all have to show some choices about what the fiscal priorities are and be actionable in ways that would give us confidence that it is going to be implemented."

Ratings Agencies Views Pulled Squarely Into US Debt Debate
by Stephen L. Bernard - Dow Jones Newswires

Ratings agencies have tried to stay above the fray in the ongoing debt drama in Washington, but whether they like it or not they are being dragged into it.

As the battle has raged ahead of an assumed Aug. 2 deadline to raise the U.S. borrowing limit, the three main agencies - Standard & Poor's, Moody's, and Fitch -- have repeatedly said their interest is in a long-term deficit reduction plan, not the details of how it is achieved. But with reports Tuesday suggesting that S&P favored a plan proposed by Sen. Harry Reid's (D-Nev.) over that pitched by House of Representatives Speaker John Boehner (R-Ohio), it's clear that their opinions are being politicized regardless.

For their part, S&P has said the reports, which appeared in a number of news outlets, were inaccurate. "S&P has been very clear not to endorse any particular plan proposed," a spokesman for the spokesman said. S&P formally released a statement later Tuesday echoing the spokesman's comments.

Such denials won't stop politicians from speculating and using the agencies in their arguments, however. Democrats have been quick to argue that Boehner's plan, which would increase the debt ceiling in a two-step process requiring a second vote on new measures next year would add uncertainty to markets, whereas Reid's proposal for a bigger $2.7 trillion increase in the debt limit pushes the problem out beyond the 2012 presidential election. The idea that ratings agencies would be more inclined to downgrade the country's coveted "AAA" rating in such an event, however accurate, strengthens that argument.

"If I thought it would work, I'd use it," said Michael Dooley, a partner at hedge fund Cabezon Investment Group in San Francisco, of the downgrade threat. "I might argue my plan is likely to have more acceptance from ratings agencies."

Reid did specifically say that in remarks on the Senate floor, arguing that Boehner's plan "gives the credit rating agencies no choice but to downgrade U.S. debt" and does not address concerns raised by credit rating firms.

To some extent, the rating agencies have created the scenario that ensures their role is politicized. Both S&P and Moody's put the U.S. government on review for possible downgrade as the debate moved closer to the Aug. 2 deadline, although Fitch said it saw no need to do so. That proactive move has been interpreted by observers as an effort by the agencies to show that they aren't going to be caught out with an overly lenient rating following the criticism that was lumped on them due to their failure to recognize the credit risks in mortgage assets before the 2008 financial crisis.

S&P has been the most aggressive. It has explicitly said even if the debt ceiling is raised, it could still cut the U.S. government's "AAA" rating if it is not accompanied by a sufficiently aggressive long-term deficit-reduction plan. In a report last week, S&P said a failure to reach a deal or raise the debt ceiling could lead to sharply higher interest rates, a steep drop in the value of the dollar and the possible need for a new bond-purchase program by the Federal Reserve.

Why the Debt Crisis Is Even Worse Than You Think
by Peter Coy - BusinessWeek

There is a comforting story about the debt ceiling that goes like this: Back in the 1990s, the U.S. was shrinking its national debt at a rapid pace. Serious people actually worried about dislocations from having too little government debt. If it hadn’t been for two wars, the tax cuts of 2001 and 2003, the housing meltdown, and the subsequent financial crisis and recession, the nation’s finances would be in fine condition today. And the only obstacle to getting there again, this narrative goes, is political dysfunction in Washington. If the Republicans and Democrats would just split their differences on spending and taxes and raise the debt ceiling, we could all get back to our real lives. Problem solved.

Except it’s not that way at all. For all our obsessing about it, the national debt is a singularly bad way of measuring the nation’s financial condition. It includes only a small portion of the nation’s total liabilities. And it’s focused on the past. An honest assessment of the country’s projected revenue and expenses over the next generation would show a reality different from the apocalyptic visions conjured by both Democrats and Republicans during the debt-ceiling debate. It would be much worse.

That’s why the posturing about whether and how Congress should increase the debt ceiling by Aug. 2 has been a hollow exercise. Failure to increase the borrowing limit would harm American prestige and the global financial system. But that’s nothing compared with the real threats to the U.S.’s long-term economic health, which will begin to strike with full force toward the end of this decade: Sharply rising per-capita health-care spending, coupled with the graying of the populace; a generation of workers turning into an outsize generation of beneficiaries. Hoover Institution Senior Fellow Michael J. Boskin, who was President George H.W. Bush’s chief economic adviser, says: “The word ‘unsustainable’ doesn’t convey the problem enough, in my opinion.”

Even the $4 trillion “grand bargain” on debt reduction hammered out by President Barack Obama and House Speaker John Boehner (R-Ohio)—a deal that collapsed nearly as quickly as it came together—would not have gotten the U.S. where it needs to be. A June analysis by the Congressional Budget Office concluded that keeping the U.S.’s ratio of debt to gross domestic product at current levels until the year 2085 (to avoid scaring off investors) would require spending cuts, tax hikes, or a combination of both equal to 8.3 percent of GDP each year for the next 75 years, vs. the most likely (i.e. “alternative”) scenario. That translates to $15 trillion over the next decade—or more than three times what Obama and Boehner were considering.

You start to see why, absent signs of a serious commitment to deficit reduction, the rating services are warning they may downgrade the federal government’s triple-A rating even if Congress does meet the Aug. 2 deadline. Fortunately, our debt hole is escapable. But digging out requires that leaders of both parties come to terms with just how deep it is.

The language we use is part of the problem. Every would-be budget balancer in Washington should read “On the General Relativity of Fiscal Language,” a brilliant 2006 paper by economists Laurence J. Kotlikoff of Boston University and Jerry Green of Harvard University (available online from the National Bureau of Economic Research). The authors write that accountants and economists have something to learn from Albert Einstein’s theory of relativity, about how measured quantities depend on one’s frame of reference. Terms such as “deficit” and “tax,” they write, “represent numbers in search of concepts that provide the illusion of meaning where none exists.”

The national debt itself is one such Einsteinian (that is, squishy) concept. The Treasury Dept.’s punctilious daily accounting of it—$14,342,841,083,049.67 as of July 25, of which just under $14.3 trillion is subject to the ceiling and about $10 trillion is held by the public—gives the impression that it’s as real and tangible as the Washington Monument. But what to include in that sum is ultimately a political choice. For instance, the national debt held by the public doesn’t include America’s obligation to make Social Security payments to future generations of the elderly. Why not?

Suppose that instead of paying Social Security payroll taxes, working people used that amount of money to buy bonds from the Social Security Administration, which they would redeem in their retirement years. In such an arrangement, the current and future cash flows would be identical, but because of a simple labeling change the reported debt held by the public would skyrocket. That example alone should generate a certain queasiness about the reliability of the numbers that are taken for granted by budget combatants on both sides of the aisle.

A more revealing calculation is the CBO’s measurement of what’s called the fiscal gap. That figure is conceptually cleaner than the national debt—and consequently more alarming. Boston University’s Kotlikoff has extended the agency’s analysis from 2085 out to the infinite horizon, which he says is the only method that’s invulnerable to the frame-of-reference problem. It’s an approach used by actuaries to make sure that a pension system doesn’t contain an instability that will manifest itself just past the last year studied. Years far in the future carry very little weight, converging toward zero, because they are discounted by the time value of money. Even so, Kotlikoff concluded that the fiscal gap—i.e., the net present value of all future expenses minus all future revenue—amounts to $211 trillion.

Yikes! Douglas J. Holtz-Eakin, a former director of the CBO from 2003 to 2005, says he doesn’t favor the infinite-horizon calculation because the result you get depends too heavily on arbitrary assumptions, such as exactly when health-care cost growth slows. But directionally, he says, Kotlikoff is “exactly right.”

Which means we’ve been heading the wrong way for years. Even in the late 1990s, when official Washington was jubilant because the national debt briefly shrank, fiscal-gap calculations showed that the government was quietly getting into deeper trouble. It was paying out generous benefits to the elderly while incurring big obligations to boomers, whose leading edge was then 15 years from retirement. Now the gray deluge is upon us. As Holtz-Eakin, now president of the American Action Forum, a self-described center-right policy institute, says: “We’re just in a world of hurt.”

The U.S. is in danger of reaching a generational tipping point at which older Americans have the clout to vote themselves benefits that sap the strength of the younger generation—benefits that can never be repeated. Kotlikoff argues that we may have reached that point already. He worries that the U.S. could become Argentina, which went from one of the world’s richest to lower-middle income in a century of chronic mismanagement.

Senior citizens are being told by their own lobbyists, repeatedly, that any attempt to rein in the cost of Social Security and Medicare is an unjust attack on earned benefits. “Stop the liberals from raiding the Social Security Trust Fund once and for all!” says a recent mailing from the National Retirement Security Task Force. Similar messages aimed at Democratic voters make the same charge against Republicans. No wonder Obama and Boehner were rebuffed by their own parties for putting entitlements on the table. In the end neither the House nor the Senate debt-ceiling proposals touched Social Security or Medicare. Not pretty.

In April this magazine ran a cover story featuring an alarmed rooster and the headline, “Don’t Play Chicken with the Debt Ceiling.” Washington clearly did not listen. The months of wrangling have dispirited the nation and concerned investors who lend money to the government. The cost of protecting against a U.S. sovereign default in the credit default swap market, while still low, is up 70 percent in the past year. It’s now nearly twice the cost of protecting against Swiss default.

A long, loud debate that produces a meaningful deal would be worth the pain, but a debate that produces next to nothing is worse for the nation than none at all. It simply calls investors’ attention to Washington gridlock. On July 14, Standard & Poor’s made that point when it placed U.S. sovereign debt on CreditWatch for possible downgrade, citing “rising risk of policy stalemate.” S&P said that “U.S. political debate is currently more focused on the need for medium-term fiscal consolidation than it has been for a decade. Based on this, we believe that an inability to reach an agreement now could indicate that an agreement will not be reached for several more years.”

Economists at JPMorgan Chase said on July 26 that continued deterioration of the U.S. government’s finances (not just a debt downgrade) might increase Treasury bond yields by 0.6 to 0.7 percentage point over the “medium term,” adding $100 billion a year to the government’s interest expenses. “That’s money being taken away from other goods and services,” said Terry Belton, the global head of fixed income strategy.

While Washington is absorbed in the composition of a budget deal—how much in spending cuts vs. how much in tax increases—that’s of secondary concern to macroeconomists. The more important figure to them is the size of the deal. The reason so many of the plans aim for $4 trillion in budget balancing is because that’s the amount that would (at least temporarily) stabilize the debt-to-GDP ratio and calm the bond market vigilantes. The downside, of course, is that if such a retrenchment is phased in too quickly it would drag down growth at a time of 9.2 percent unemployment.

Some economists, such as Holtz-Eakin, say any hit to growth would be small and worthwhile. “Weak-kneed Keynesians—I’m not one of those,” he says. Others would favor shifting the balancing until after 2013, when the economy presumably will have strengthened. “In our view, the U.S. does not need an aggressive near-term fiscal tightening,” Ian Shepherdson, chief U.S. economist of High Frequency Economics, wrote to clients on July 21. A third group, led by Princeton University economist and New York Times columnist Paul Krugman, says the economy needs more stimulus in the short run, not less. The logic: Getting the economy back to full speed would increase tax revenue and shrink the fiscal gap more effectively than draconian cuts. Of course, this fiscal debate is moot if the deal on the debt ceiling is just a stopgap that’s too small to have a real impact on the macroeconomy—a prospect that’s pretty depressing all by itself.

If America’s long-term budget problems were small, they could be fixed entirely by the Republicans’ preferred method, which is spending cuts, or entirely by the Democrats’ favored fix, tax increases. The challenge is not small, however. That’s why nearly every bipartisan group that’s looked at the problem—including the Bowles-Simpson and Domenici-Rivlin commissions—has concluded that some mix of the two will be required. The precise mixture is a political matter, but one would have to place an exceptionally high priority on the well-being of upper-income taxpayers to conclude that none of the adjustment burden should fall on them.

Republicans in Congress, not wanting to appear to defend the rich, have attempted to block any deal that includes higher taxes on the grounds that tax hikes are “job-killing.” But experience shows that in a period of slack demand like the present, tax hikes are no more job-killing than spending cuts, and probably less so. Cutting spending—say, by firing federal employees or canceling procurement—removes demand from the economy dollar-for-dollar. A dollar tax hike, on the other hand, especially one aimed at upper incomes, cuts demand by less than a dollar. Those who pay the tax cover part of it from their savings and only part by reducing their spending. If lawmakers insist on using the phrase “job-killing,” Roberton Williams, a senior fellow at the Brookings Institution-Urban Institute Tax Policy Center, wrote in a recent blog post, “they should apply it equally to both tax increases and spending cuts.”

There is one respect in which the national debt—all $14,342,841,083,049.67 of it—is a good measure of the problems facing the U.S. It’s real money that’s owed to real creditors. (Actually, some is intra-governmental, so only about $10 trillion is owed to the public.) “The numbers are hard enough. The creditors know how much they lent and how much they expect to get back,” says former Congressman Bill Frenzel, the ranking Republican on the House Budget Committee in the 1980s.

In contrast, the fiscal gap captures commitments to future spending and revenue—and while that makes the numbers more daunting, it also means that it’s in our power to change them. They will have to be changed sometime, because current trends are unsustainable. The sooner the adjustments begin, the more gradual they can be. It’s easier to slow down from 70 mph by stepping on the brakes than by slamming into a wall.

The good news is that this speeding vehicle does have brakes—if Washington would only use them. Eliminating deductions would broaden the base of income that’s subject to taxation and increase revenue. On the spending side, it’s crucial to change the incentives that lead to overconsumption and inefficiency in health care. At the same time, cuts in benefit formulas for Medicare and Social Security are painful but necessary. And they should apply at least in part to current beneficiaries. Given how hard-pressed young workers are, it’s unfair to put all the adjustment on them while completely insulating today’s elderly.

Sure, it’s hard to imagine a real deal now, as Washington boils over with anger and partisan differences harden. But from this bitter experience may come a realization that the only way out is cooperation and compromise in the public interest. Meanwhile, that rooster we put on our cover in April? He’s having a heart attack. Let’s not do this again soon.

The Kabuki theatre of America's Debt Ceiling
by Ambrose Evans-Pritchard - Telegraph

Calm down. The US will not miss a coupon payment on its $14.3tn debt next Wednesday.

A genuine default would be "Lehman on Steroids" in the words of Ex-Treasury secretary Larry Summers. Precisely for that reason President Obama will not pull the trigger, EVEN IF the debt ceiling talks break down in acrimony. Obama still has a clutch of cards to play, in extremis. As Yves Smith from Naked Capitalism argues, the White House can challenge the constitutionality of the debt ceiling in Congress.

The 14th Amendment of the Constitution states that the "validity of the public debt of the United States shall not be questioned". Such recourse would kick it up to the Supreme Court, which would take its own sweet time. (Fortuitously a complex matter.) Bill Clinton advised Obama to do just that: blaze ahead, break the debt ceiling in defiance of Congress, and "force the courts to stop me".

Or, the US Treasury could eliminate the Fed’s entire holding of Treasury bonds at a stroke, gaining an extra two years. This would be a simple accounting transaction. Ben Bernanke might feel uncomfortable, and gold might blast to $3,000, but the Bernanke Fed has proved itself supple. The Treasury also has the authority to issue infinite amounts of platinum coins at any denomination it chooses (ie, like fiat paper currency, far above the metallic value): a chest of $1bn coins, say. This is seignorage on steroids, pace Prof Summers.

You get the drift: nothing will in fact change when the deadline expires on August 2. The US is the world’s paramount strategic and economic power, with debts in its own sovereign currency. It can do as it pleases. Yes, the US may be stripped of its AAA by Standard & Poor’s. A nice one-day story, but otherwise irrelevant. Global bond vigilantes are quite able to make their own judgement on the substantive default risk of the US. The rating agencies are out of their league on this one.

(By the way, the serial downgrades of Japan did not stop the yield on 10-year Japanese bonds falling to 0.5pc at one stage. What matters is whether investors really believe that they will be stiffed. In Japan they did not, and still do not.)

Clearly, the bond markets do not yet take the threat of US default seriously, though currency markets are less sanguine. I know this puzzles many in Europe, and angers some, but the cold reality is that yield are still just 0.4pc on 2-year US debt, and 3.02pc on 10-year bonds. Those of us who have lived through many such soap operas on Capitol Hill (I covered the Clinton-Gingrich debt stand-off in 1995 during my Washington years, as well as a few under the elder Bush and even Ronald Reagan) watch this brinkmanship with a jaundiced eye.

Perhaps for that reason, we may be caught off guard (just as veteran gold analysts were the last to understand that gold was in a bull market early. We stick lazily to our outdated paradigms). This time the drama certainly has a more threatening feel, and it comes at moment when sovereign states themselves have lost their sanctity.

I did not like the tone of President Obama’s speech. Rather than trying to find a way out of the impasse, he seemed to be preparing the ground to blame Republicans for default. That creates a very nasty mood.

An epic battle is undoubtedly under way over the future shape of America: whether it should return to the frontier spirit and low taxation of the early Republic, or ratchet ever upwards towards cradle-to-grave welfare and Euro-paternalism. And, of course, whether it really does drift towards bankruptcy down the road.

My sympathies are with those want to shrink the federal state, though I am not quite willing to join the chorus of abuse against President Obama. He has pledged to cut Social Security and the big entitlements of Medicare and Medicaid, and did at one stage commit himself to a $4 trillion fiscal squeeze over ten years, much to the fury of arch-Keynesians such as Paul Krugman. It is not clear to me that John Boehner’s Republicans are more fiscally rigorous, or genuinely willing to cull the sacred cows of entitlement.

(The great health care cartel is in my view the villain here. It is the root cause of US ruin, and is itself responsible for the epidemic of diabetes, Alzheimers, and several other mass ailments afflicting America. It has systematically failed to keep up with the scientific literature, and refuses to abandon grievous policies when shown to be wrong. Americans need to confront this huge vested interest (nearly a fifth of GDP) before it destroys the country. But that is a rant for another day.)

S&P cited Winston Churchill in its downgrade warning that "you can always count on Americans to do the right thing after they’ve tried everything else." Or to quote the other Clinton as she tried to reassure Asians holding of $3 trillion of US bonds: "the political wrangling in Washington is intense right now. But these kinds of debates have been a constant in our political life throughout the history of our republic"

"Sometimes they are messy, but this is how an open and democratic society ultimately comes together to reach the right solution."

Exactly. If I am wrong, we will all need to take shelter in nuclear bunkers next Wednesday.

Insiders Become Outsiders as Lobbyists Shut Out of Debt Debate
by Alison Fitzgerald and Kristin Jensen - Bloomberg

Sweltering in the heat at his son’s lacrosse tournament, Joseph Stanton sat thumbing through his blackberry -- laptop nearby -- as he tried to track developments in Washington’s debt debate.

The chief lobbyist for the National Association of Home Builders started his work on July 24, a Sunday, at 7:30 a.m. and finished about 8 p.m., knowing little more than he did in the morning about whether the housing market would be hit in a deal. "There’s really just mass confusion everywhere, not on Congress’s part, but the rumor mill of the lobbying world," said Stanton, 49. Asked how the debt-deal talks compare in terms of their frenetic atmosphere with other debates Stanton’s seen in his two decades of advocating on Capitol Hill, he said: "This is in the top one."

Lobbyists earn their salaries by getting information about what’s moving on Capitol Hill, who’s behind it, and how they can amend it to help their clients. With almost every government program, tax and payout potentially affected by a deficit- reduction agreement needed to pave the way for raising the $14.3 trillion debt ceiling to avoid a projected Aug. 2 default, lobbyists are finding it hard -- if not impossible -- to do their jobs.

Lab Co-Payments
With President Barack Obama and congressional leaders conducting closely held private meetings in search of an accord, "it’s been very difficult to get information from them and into them," said Mark Birenbaum, head of the National Independent Laboratory Association. His group is trying to follow the status of a Republican proposal that would require labs to collect a co-payment from Medicare patients.

Michael Buckley, communications director at the Alliance for Retired Americans, said his group has opted to save its energy for the post-deal period, when hundreds of billions of dollars in spending cuts tied to the debt ceiling vote are expected to be implemented. "There are only a handful of people in this town that are the decision-makers on this now," he said.

Other groups are trying to advance their positions by getting ahead of the final negotiations. Groups such as the anti-government spending Tea Party Patriots to the seniors’ advocacy group AARP are marching members up to Capitol Hill. The oil industry, religious groups, unions and a political organization advised by Republican strategist Karl Rove are running ads to influence the negotiations.

Tea Party
Tea Party Patriots members, who oppose raising the debt ceiling, last week met with more than 30 House members and staffers, along with a handful of senators. About two dozen Tea Party activists gathered outside the Capitol yesterday, urging members to oppose any increase in the debt ceiling that isn’t accompanied by a constitutional amendment to balance the budget "I pledge to you that I will not vote for any bill that raises the debt ceiling," Representative Paul Broun, a Georgia Republican, told the flag-waving crowd.

The country takes in enough money to pay bondholders, Social Security recipients, and the military without raising the ceiling, said Jenny Beth Martin, co-founder of the Tea Party Patriots, in an interview. "When President Obama is saying we are going to default," Martin said, "it’s a lie."

Cuts, Taxes
Proposals floated during the last two weeks of talks include cuts to farm subsidies, defense spending, Social Security, Medicare and Medicaid. They’ve also included hikes in taxes on the rich and the reduction of tax breaks for private equity firms, oil companies and home owners.

The July 22 collapse of talks between House Speaker John Boehner and Obama for a deal to revamp the government’s finances through both spending cuts and a tax overhaul left lobbyists with no proposal to review and lots to worry about through the weekend. The situation didn’t improve this week when competing deficit-cutting plans proposed on July 25 by Boehner and Senate Majority Leader Harry Reid also contained few specifics.

The 10-year plan introduced by Reid calls for more than $2 trillion in cuts and savings to defense and non-defense discretionary spending -- programs whose budgets are set in Congress’s appropriations process. It includes changes to the federally chartered housing finance agencies, cuts in agriculture subsidies, changes to eliminate waste and fraud and an auction of additional spectrum.

Boehner’s plan, which has undergone revision, would require two separate phases of cuts totaling close to $3 trillion. Both lawmakers would create a committee to choose specific budget cuts later.

Housing Issues
Stanton, of the Washington-based homebuilders group, is concerned about tax proposals that have been discussed to eliminate the deduction for home mortgage interest, the credit for low-income housing and an increase in the rate on carried interest. "Any one, or partial one of these, could certainly send an uncertain housing market further into the abyss," he said. It’s a message he and his association members have been repeating to anyone on Capitol Hill who will listen.

He’s not alone. The Washington-based American Petroleum Institute is organizing a "fly-in" this week of refinery workers and executives to meet with lawmakers and make the case that the industry creates high-paying jobs and already pays more taxes than most. "We’re doing the old-fashioned burning the leather on Capitol Hill and we’re activating our grassroots," said Eric Wohlschlegel, a spokesman.

Ad Campaign
The group is also running TV, radio and print advertisements across the country. "America needs more energy jobs, not more energy taxes," the ad says. Sojourners, a Washington-based group of religious leaders, is running radio ads in Kentucky, Ohio and Nevada pushing lawmakers to protect programs for the poor. Crossroads Grassroots Policy Strategies, the group advised by Rove, is spending $10.5 million on two ads saying the U.S. economy is "hanging by a thread" and that, "There’s got to be a way to take away President Obama’s blank check." The Service Employees International Union is airing commercials in the House districts of some Republicans accusing them of risking default to "protect tax breaks for millionaires."

Senior Citizens
Social Security Works, a coalition that includes labor unions, groups representing retirees, and advocacy organizations such as the NAACP, sent a dozen senior citizens from Maryland to walk the halls of Congress and argue that the government pension system isn’t the cause of the debt and shouldn’t be cut, said Don Owens, the communications director. Last week, the group organized a telephone lobbying effort, urging 30,000 seniors to call their representatives. "Our sole focus is ensuring Social Security is not the end-all bargain to getting the debt ceiling raised because Social Security is not contributing to the debt," Owens said.

AARP has used its membership lists to generate what it claims are 243,000 calls to members of Congress and the White House, as well as more than half a million e-mails. "We’re talking about the health programs, Social Security, the tax code, you’re talking about all of government," said David Certner, AARP’s director of federal affairs. Julie Allen, a lobbyist who represents the independent labs, said "every day is a new day on this one. At some points, it felt like it was minute to minute. It’s insane."

Europeans Urge US to Reach a Deal
by Gregor Peter Schmitz - Spiegel

US lawmakers and President Obama have until Aug. 2 to find a compromise on raising the federal debt ceiling before the government goes into default. But talks have broken down between the White House and Congress, and Republican and Democratic proposals in Congress appear to be going nowhere. The IMF and some European leaders are calling on the US to get its act together.

The daily schedule of a member of the US Congress has been easy to predict recently. In the morning, the legislators in Washington stand in front of the TV cameras and talk about, one after another, how the country is standing on the edge of the precipice. Then, in the evening they can go back and report that the country did make one small step forward.

Tuesday was no exception. Chaos and internal power struggles ruled, this time within the Republican party. The conservative leaders around John Boehner, the powerful Republican speaker of the House, had wanted to promote their own plan for raising the debt ceiling, but he was forced to postpone a vote on the measure late in the day. If Congress does not raise the debt ceiling by August 2 from its current level of $14.3 trillion, the United States will default on its debt.

Boehner's plan would involve raising the debt ceiling initially by $1 trillion, which is enough to pay off federal debts until the end of the year. That would be offset by spending cuts of $1.2 trillion over the next decade. In addition, a commission would then determine how further spending cuts and adjustments to the tax code could be made.

No Republican Consensus
Boehner wanted a vote on his proposal to take place as early as Wednesday in the House of Representatives, but on Tuesday night he had to announce that he was pushing that back at least one day because he did not have a clear majority behind it.

The independent Congressional Budget Office in the meantime has calculated that Boehner's savings would only amount to about $850 billion -- which would be less than his promised rise in the national debt limit, and too little for conservative hardliners from his own party, who want to shrink the deficit by as much as possible.

It was already unclear before the proposal how many votes Boehner could count on from his own party. His spending cuts did not go far enough, especially for those aligned with the radical Tea Party movement. Some of them oppose any form of compromise on the debt ceiling limits. "I will not vote for the increase," said the Republican presidential candidate Michele Bachmann, a darling of the Tea Party movement.

'Dead on Arrival'
The blow to Boehner has heightened the level of insecurity in Washington, just as the deadline for a US default looms. Still, the Republicans around Boehner had hoped that the plan could make its way through the Senate, which is controlled by the Democrats, even though Harry Reid, the Democratic leader of the Senate, opposed it. "Boehner's plan is no compromise," Reid said. "It was written for the Tea Party, not for the American people." On Tuesday, he declared it "dead on arrival" in the Senate.

Reid's Democratic colleagues in the Senate are working on their own proposal. Their plan would include about $2.7 trillion in spending cuts, but no significant cuts to social programs that the Democrats consider especially important. Tax increases -- a red flag for Republicans -- are also taboo in this plan, for the time being. At the same time, the US debt ceiling would be raised to the same level. The US government could remain solvent under this plan at least until the end of 2012, and US President Barack Obama would not have to enter into another debate on the debt ceiling in an election year.

But Democrats didn't have time to rejoice over Boehner's setback because their plan also does not have a clear majority behind it. Washington threatens to spiral into a world of misunderstandings, bruised egos and political games, which could lead directly to a national default.

40,000 Phone Calls in One Hour
On Monday, the fallout was there to be seen on primetime television. President Obama addressed the nation from the White House and accused the Republicans of waging a "political war." As if he were in the middle of an election campaign, Obama called on his supporters to pressure their members of Congress with phone calls and e-mails, and they did. On Tuesday, Speaker Boehner's website crashed several times, and at one point about 40,000 calls were made to the House in one hour.

Boehner appeared immediately after the president on television and said: "[Obama] wants a blank check today, and that is just not going to happen." Boehner, who until recently was Obama's negotiating partner, is now only working as the opposition leader. But in this political dogfight there do not appear to be any winners. The conservative Boehner has been weakened because he can't rally the members of his own party behind him. In Republican circles, the topic of who will be his successor is being discussed.

Obama, on the other hand, can build on polls that show the majority of Americans, like him, want a compromise to be reached in the debt talks and reject the radical agenda of the Tea Party movement. Still, recent polls show that Obama's approval ratings among African-Americans and liberals have fallen dramatically. These groups grumble about Obama's willingness to compromise, and he needs their support for re-election next year.

A Plea from Lagarde
And the world economy? It could be the biggest loser of all.

"The clock is ticking, and clearly the issue needs to be resolved immediately," Christine Lagarde, the new head of the International Monetary Fund (IMF), said at a speech in New York on Tuesday. If the ratings agencies were to downgrade the credit rating of the United States, or if the country were to default, it would be a "very, very serious event, not just for the United States, but for the global economy at large," Lagarde warned. She said a fiscal shock in the United States could have repercussions for the rest of the world.

German media commentators have also expressed their concerns. On Wednesday, the conservative newspaper Die Welt wrote: "If government bonds were affected, then there would be a collapse on the international financial markets with unforeseen consequences for the real economy."

The French budget minister, Valerie Pecresse, also weighed in on Wednesday, saying: "We think the global economy needs an American agreement ... We need a deal not just on the question of the American debt but also on rebalancing American public finances."

Into the Abyss
But a compromise is not in sight. Instead, experts in Washington have begun to debate whether or not a deal really needs to be reached by August 2, or if the US has more money left over than originally thought. The consensus is that the government will not run out of money until August 10, writes the New York Times. By then, they must borrow more money in order to send out millions of social security checks. If not, they will become insolvent.

August 10 instead of August 2. One doesn't want to think about it: yet another week of collectively marching toward the abyss.

Greek bail-out was a one-off, says German finance minister Wolfgang Schaeuble
by Louise Armitstead - Telegraph

The German finance minister has warned that he will not bail out every troubled eurozone country in a move that rattled confidence in Europe's response to the debt crisis.

In a strongly worded report to German parliamentarians, Wolfgang Schaeuble explained that the €159bn Greek bail-out was a one-off. He said: "In the future such purchases must only take place under very tight conditions, when the European Central Bank establishes that there are extraordinary circumstances in financial markets and dangers to financial stability."

Mr Schaeuble echoed German Chancellor Angela Merkel, who said the union's bail-out fund, the European Financial Stability Facility (EFSF), should not be allowed to engage in "unconditional" buying of bonds from stricken members.

Traders interpreted the letter as a strong signal Germany could not be depended upon for standing by the euro indefinitely. Just a week after European authorities united to rescue Greece, experts fear authorities are already again struggling to contain the region's sovereign debt crisis.

Cyprus threatened to become the fourth eurozone country to need a bail-out after Standard & Poor's downgraded its debt further into junk territory, lowering it to CC from CCC. The rating agency raised concerns that Cyprus' large exposure to Greek bonds - which is among the highest in the eurozone - might hamper its ability to service its own sovereign debt.

According to the European Banking Authority, Bank of Cyprus holds €2.4bn in Greek debt and Marfin Popular Bank holds €3.4bn. Yields on Cypriot bonds maturing in 2014 soared to 10.18pc - above the borrowing rates of Ireland and Portugal, which have both been bailed out. Stock markets across Europe fell. German's Dax was down 1.3pc; the CAC in France was down 1.4pc and Spain's Ibex was down 2pc. In London the FTSE 100 dropped 1.2pc.

Italian banks were hard hit amid fears of their sovereign debt exposure - UniCredit slid 3.9pc while Intesa Sanpaolo dropped 4.2pc. The euro fell from a three-week high against dollar. Michael Woolfolk, from Bank of New York Mellon, said: "The immediate crisis has passed, but it hasn't fixed the underlying problems, and that's why the market has been less than excited about holding euros. [America] will find a compromise that cuts spending and is unlikely to lead to a debt downgrade, and then the focus will once again turn to Europe."

Separately, the International Monetary Fund cautioned France that it would miss its growth targets unless "specific contingency measures" were imposed immediately. The fund, which was carrying out its yearly review of France, said it expects the economy to expand at a slower rate than Paris forecasts – at 2.1pc this year compared with 2.25pc. The IMF said France, Europe's second-largest economy, would have to adopt spending cuts or miss its target of reducing its budget deficit to 3pc of output by 2013.

Francois Baroi, the French foreign minister, said the cabinet was set to approve the Greek bail-out plans next week but parliamentarians will not vote on the package until October.

IMF warns France on budget deficit
by James Boxell - FT

The International Monetary Fund has warned that France will miss its target of cutting its budget deficit to 3 per cent of output by 2013 unless it carries out more spending cuts.

In a yearly review of the French economy, the Washington-based fund said it expected economic growth and tax revenues to be below the government’s own forecasts. The country’s economy will expand by 2.1 per cent this year and 1.9 per cent in 2012, it said.

As a result, Nicolas Sarkozy’s government should prepare "specific contingency" measures for meeting deficit targets in case growth falls short and limits tax receipts. Paris expects gross domestic product growth to accelerate from 2 per cent this year to 2.25 per cent next year, but some analysts have warned that those forecasts look generous.

The IMF said the fact that the country’s tax rates were already high meant the French president had little choice than to target spending, particularly in pensions and healthcare. François Baroin, finance minister, welcomed the report for offering support for Mr Sarkozy’s push for a so-called "golden rule" in the French constitution, which would force future governments to issue three-year plans to balance budgets.

The IMF said the rule change, strongly opposed by the opposition Socialists, would "entrench fiscal credibility". However, the fund’s comments also herald potentially difficult choices for the Sarkozy government ahead of next year’s presidential vote as he balances the need to rein in spending with his political imperative of winning an election.

Valerie Pécresse, the French budget minister, insisted the 3 per cent deficit target remained "sacrosanct" and that the government could cut further the country’s generous tax exemptions if growth slowed. The IMF said measures taken by the government had helped "a gradual recovery from the crisis" but warned of the residual threat of "spillovers" from elsewhere in the eurozone. Mr Sarkozy was at the forefront of last week’s second rescue deal for Greece, alongside Angela Merkel of Germany.

However, the fund urged further structural reforms in France to improve competitiveness and boost growth, with the country’s strict employment protection laws a particular worry. It said steps were needed to cut medium-term spending to safeguard France’s top-notch triple A rating.

"Under staff’s current projections, achieving the deficit target of 3 per cent of GDP by 2013 requires further measures," the report said. "France cannot risk missing its medium-term fiscal targets given the need to strengthen implementation of the Stability and Growth Pact (SGP) and keep borrowing costs low by securing France’s AAA-rating."

Mr Sarkozy’s attempts to break his country’s reliance on deficits, which stretches back 35 years, has also been welcomed by credit-rating agencies, who think the draft constitutional change could increase France’s credibility in financial markets. In 2010, the French deficit was 7.1 per cent of GDP, compared with 3.3 per cent for Germany.

Eurozone crisis fears continue as Italy forced to pay higher rates to borrow
by Telegraph

Italy came under fire from financial markets on Thursday amid further fears the eurozone's third biggest economy could join Greece, Ireland and Portugal into a debt spiral. The Treasury had to pay sharply higher rates to sell off €8bn in bonds including 4.80pc on bonds due in 2014 that had last sold for 3.68pc, and 5.77 percent on bonds due in 2021 compared with 4.94pc before.

Italy's benchmark FTSE MIB index fell as much as 2pc, while the difference between the rate of return on Italian and German 10-year sovereign bonds - a key measure of the financial risks as perceived by investors - rose to near-record highs of around 330 basis points. The euro also fell by a cent against the dollar to $1.4269 and by 0.7cents against sterling to £0.8745.

Investors are concerned that the Italian economy, suffering from high public debt, low growth and growing infighting in the government could follow Greece, Ireland and Portugal into a debt spiral that has thrown the eurozone into crisis. Tensions on the Italian bond market went down after a second bailout for Greece was agreed at a summit in Brussels last week but have returned on concerns over the details of the Greek rescue plan and US debt fears.

"You really feel that the European plan has not calmed the market at all," said Jean-Francois Robin, a bond market strategist for French bank Natixis. The rise in the yields is "a bit disappointing," said Robin, pointing to sweeping budget austerity measures adopted by Italy's parliament this month.

The auction jitters came alongside a report that showed eurozone economic sentiment worsened more than expected in July, with business optimism falling in all sectors. The European Commission's monthly economic sentiment index fell to 103.2 in July from 105.4 in June, its lowest reading since 102.2 in August 2010.

Europe's hot summer as Italy and Cyprus join sick list
by Ambrose Evans-Pritchard - Telegraph

Fears of recession in Italy and the Germans' reluctance to back the EU's bail-out fund with real muscle have set off fresh eurozone tremors, pushing yields on Southern European bonds back to levels seen before last week's emergency summit.

News that Moody's had downgraded Cyprus two notches from A2 to Baa1 due to "fractious politics" and exposure to Greece compounded fears Europe's crisis is far from resolved. The darkening picture in Cyprus raises concerns that a fourth eurozone country might soon need some sort of rescue, exhausting bail-out tolerance in Germany, Holland, Finland and Slovakia, where a wing of the coalition has denounced the EU accord.

"The markets have started to see all the flaws in the summit deal," said David Owen, of Jefferies Fixed Income. "They know there has been no increase in the size of the European Financial Stability Facility (EFSF) and that it will not be any position to intervene in the Spanish and Italian markets for quite some time because the changes have to be ratified by all parliaments." "Unless the European Central Bank (ECB) steps in to buy bonds, this is going to be tested by markets over the summer. EU leaders have sent absolutely the wrong signal by thinking they have done the job and can now go on holiday," he added.

Yields on Italian 10-year bonds spiked to 5.8pc on Wednesday while Spanish yields punched through 6pc once again. Analysts remain perplexed by the decision of Italy's treasury to cancel bond auctions in mid August due to lack of liquidity and "reduced financing needs". Italy was expected to raise €68bn (£60bn) in August and September.

German finance minister Wolfgang Schauble has told key Christian Democrats that there will be no "blank cheque" for EFSF operations, and cautioned against thinking "the crisis of trust in the euro area can be conclusively ended by a single summit". Investors suspect Germany is again talking with a forked tongue, promising one thing in Brussels and another at home. The revamped EFSF can lend €440bn, but a chunk is already needed for Portugal, Ireland and a second Greek rescue. City economists say the fund needs €2 trillion to quell doubts.

Professor Nouriel Roubini from New York University said the EFSF package does not go to the heart of the problem. "For over a decade the peripheral states have lost competitiveness against China, Asia, Turkey and East Europe. Their products are labour-intensive and generate little added value. The sharp rise in the euro has ruined the competitiveness of these products. That is the nail in the coffin."

Italian bank stocks fell sharply in Milan as the mood soured, with Intesa down 5pc and Unicredit off 4pc. Deutsche Bank said it had cut its exposure to Italian debt from €8bn to €1bn since the end of last year, mostly by purchasing credit default swaps (CDS). The Deutsche revelations suggest Europe's banks have been the main buyers of Italian CDS for hedging purposes, rather [than] speculators as claimed by Italian leaders.

The economic outlook continues to darken in Italy. The manufacturing index fell for a fourth month in July, dipping below the contraction line of 100. Italy's business lobby Confindustria said growth would be "almost nil" this quarter, adding the ECB's rate rises have become "an obstacle for recovery and deepened problems for debtors". The group's leader Emma Marcegalgia said Italy's political system was unravelling, leaving industry to its fate.

Michael Gavin from Barclays Capital said the EU authorities had themselves triggered the debt crisis in Italy by demanding banks and creditors share the pain in Greece, a shift in strategy that caused investors to re-examine other countries. The financial support apparatus became a "default machine" instead, raising fears Italy could be drawn into a "downward spiral". Mr Gavin said Italy's current account deficit has been slowly deteriorating for 15 years and is now 3.5pc of GDP, despite the compression of internal demand. Net foreign liabilities have reached 26pc of GDP. "The markets appear to be reserving judgment, so are we," he said.

Jens Larsen, chief economist at RBC, said Italy's debt has a relatively long maturity at 6.8 years, giving it a cushion of security for now. "This is not an immediate and present danger." The trouble in Cyprus is an unsettling development. The island has suffered much the same loss of competitiveness as Greece within EMU, with a current account deficit peaking at 17pc of GDP in 2008. While debt below 70pc is manageable, growth has slumped to zero and the budget deficit may top 7pc this year. The economy was already struggling before an explosion knocked out the main power station at Vasikilos.

Meanwhile, the International Monetary Fund warned that France is "highly vulnerable to growth spillovers from a shock in Spain, while spillover effects from Italy are also large". The IMF said France had the highest debt to GDP ratio of any AAA state this year at 85pc, just above Britain, and would need to tighten fiscal policy further to meet its target of 3pc deficit by 2013.

Cyprus faces triple wave of trouble
by Peter Spiegel and Joshua Chaffin - FT

Everything that could possibly go wrong for Cyprus appears to have done so – in just a fortnight.

European officials have long been concerned about the country’s domestic banking sector, which has assets of more than seven times its annual economic output – giving it a disproportionate role in the island’s economy. The banks weathered the global financial crisis and the initial stages of the eurozone’s debt crisis relatively well.

But then came last week’s decision by European leaders to put pressure on Greek bond owners to accept losses on their holdings. This had an exaggerated effect on Cypriot banks, two of which are among the largest holders of Greek bonds in Europe.

Even as European leaders were causing turmoil in the bond market as they dithered over the size and scope of Greek bondholder losses, another drama was unfolding in Nicosia: the Communist-led government was locked in a bitter fight with trade unions and rival parties over an austerity programme to get its deficits under control.

Just last month, the European Commission warned that without such modifications, Cyprus would not achieve its European Union-mandated budget targets. Then, as if a banking crisis and a political crisis were not enough, a much more grisly disaster struck.

Two weeks ago, the country’s largest power plant blew up after a cache of Iranian munitions confiscated by authorities exploded, killing 13 people. The fallout from the trio of disasters has plunged the island’s government, long known for its military standoff with the Turkish half of the country, into a different kind of chaos, which the head of its central bank likened to the 1974 Turkish invasion that split the island.

Ministers have resigned amid accusations that they may have known of the danger posed by the Iranian munitions. Protesters have taken to the street demanding even more scalps. And the much-needed austerity programme has become a casualty of the fallout. As a result of that strain, the government announced on Wednesday that Demetris Christofias, the president, was to ask for the resignation of all members of his cabinet at a meeting today. This followed the junior party in the governing coalition, the Democratic party, urging its ministers to resign.

In its announcement downgrading Cypriot bonds on Wednesday, Moody’s Investors Service cited political upheaval as a primary reasons for its change in opinion. For the EU and other European leaders, however, it is the banking sector that has been the focus of concern. Nearly 40 per cent of all loans extended by Cyprus’s three largest lenders – which account for 55 per cent of the country’s total bank assets – are to customers in Greece.

In addition, stress tests released by the European Banking Authority this month showed that, among non-Greek banks, two Cypriot groups – Marfin Popular Bank and Bank of Cyprus – were the third-largest and seventh-largest holders of Greek bonds in Europe. Constantinos Pittalis, head of investor relations for the Bank of Cyprus, said on Wednesday that the bank had reduced its exposure to Greek bonds by about €700m ($1bn) to €1.7bn since the stress tests were held as some of the debt matured and some was written down.

But the holdings still raised concerns at Moody’s, which said Nicosia would probably have to recapitalise the banks. Although the potential Greek debt hole in Cyprus is not as large as the losses faced by banks in Ireland, it is still large for a country with a gross domestic product of €17bn.

Moody’s downgrades Cyprus bonds
by Peter Spiegel - FT

Moody’s announced Wednesday that it was downgrading Cyprus’ government bonds two notches, to just above junk levels, in the latest sign the island nation may become the fourth eurozone country heading towards a multibillion-euro bail-out.

In its downgrade announcement, which moved the sovereign bonds from A2 to Baa1 and put them on a negative outlook, Moody’s cited the economic impact of the recent explosion at the island’s main power plant and the "increasingly fractious" political climate in the wake of the blast, which has led to ministerial resignations and halted government austerity plans.

But it also cited Cypriot banks’ exposure to Greek debt, which is expected to be ruled in default after eurozone leaders on Thursday agreed a deal which puts pressure on Greek bond owners to trade in their current holdings for bonds of a lesser value.

"Cypriot banks remain heavily exposed to macroeconomic stress and Greek government bonds," Moody’s said in its downgrade announcement. "A period of prolonged macroeconomic stress would increase the likelihood that these contingent liabilities will crystallise on the Cypriot government’s balance sheet."

It was a similar bank bail-out in Ireland, coupled with rising borrowing rates caused by a run on government bonds, which forced Dublin to accept a bail-out from the European Union and the International Monetary Fund in November.

According to recent bank stress tests conducted by the European Banking Authority, Cypriot banks are among the largest holders of Greek bonds in the entire eurozone. Bank of Cyprus holds €2.4bn in Greek debt and Marfin Popular Bank holds €3.4bn.

Cyprus President Dismisses Cabinet as Crisis Worsens After Blast
by Stelios Orphanides - Bloomberg

Cypriot President Demetris Christofias ordered his cabinet to resign as political discord deepens after a munitions blast wrecked a main power plant and Moody’s Investors Service cut the government’s credit rating.

Christofias requested and received the resignations of his government ministers today, spokesman Stefanos Stefanou told reporters in Nicosia. The president wants to consult government parties about the formation of a new administration, which will happen "soon," Stefanou said.

Cyprus’s prospects are deteriorating after a blast at a munitions depot on July 11 knocked out more than half of the country’s power generation, which Credit Suisse AG estimates may cost the economy 14 percent of gross domestic product. On top of that, Moody’s yesterday said there’s a "material risk" that losses on Greek debt holdings will force the country’s banks to seek a bailout "over the next few years."

Cypriot bonds have slumped, pushing their yields close to the levels on Irish and Portuguese debt. Both countries have been forced to follow Greece in seeking a European Union-led bailout. The yield on Cyprus’s 10-year bond maturing in February 2020 was at 10.05 percent today from 6.22 percent three months ago. Yields on similar-maturity Irish and Portuguese bonds are at 11.16 percent and 10.84 percent, respectively. Cyprus will not need to ask the EU for help as it has already covered its financing needs for this year, Stefanou said.

Crisis Path
Cyprus’s economy, the euro area’s third-smallest, expanded 1 percent last year and the government posted a budget deficit equivalent to 5.3 percent of GDP. Public debt is expected to peak at 62 percent of economic output in 2012, compared with 61.6 percent this year and 60.9 percent in 2010, according to the Ministry of Finance. Outstanding debt at the end of last year was around 10.6 billion euros ($15.2 billion).

"We are not at a point where Cyprus is the next to join Greece, Portugal and Ireland," said Padhraic Garvey, head of developed-market debt at ING Bank NV in Amsterdam. "Cyprus is also tiny compared with other stressed peripheral issuers, and hence it is more of a sentiment issue than something that materially affects the path of the crisis." Garvey said there is "no immediate need for panic" on Cyprus’s funding needs.

The east Mediterranean island’s president yesterday asked the ministers in his coalition government of communist AKEL and center right DIKO to submit their resignations. His request followed the resignation of the two remaining DIKO ministers in his government, who were asked to do so by their party chairman Marios Garoyian hours earlier.

The July 11 explosion at a munitions depot which knocked out the Vasilikos power plant accounted 53 percent of total power generation capacity and has amplified fiscal concerns, Moody’s said. The rating company downgraded Cyprus from A2 to Baa1, the third notch above non-investment grade. On July 26, negotiations between the government and the rest of Cyprus’s political parties on a proposed austerity package collapsed.

Cyprus awash in a tide of troubles (July 21)
by FT Editorial

As Europe’s leaders strive to devise a solution to the sovereign debt crisis, they are understandably concentrating on the 17-nation eurozone as a whole, not the small corner represented by Cyprus. Yet the tide of troubles that has engulfed Greece, Ireland and Portugal is threatening to wash over the east Mediterranean island that for decades has been best known for incubating one of Europe’s oldest diplomatic disputes.

Athanasios Orphanides, Cyprus’s central bank governor, warned this week that the economy faced an emergency similar to that of 1974, when Turkish forces invaded the island after an abortive Greek-inspired coup aimed at uniting Cyprus with Greece. It was a somewhat over-the-top comparison. But he was closer to the mark when he suggested that, without a more determined effort to clean up the public finances and introduce structural reforms, Cyprus might need a financial rescue package similar to those negotiated for Greece, Ireland and Portugal over the past 14 months.

The governor’s comments illustrated how, in these dangerous times, a eurozone member state usually well out of the spotlight can easily succumb to a combination of extravagant budget deficits, contagion channelled through the banking system, government incompetence and sheer bad luck.

Cyprus does not face short-term funding difficulties, but its bond yields have risen sharply in recent months, pointing to investors’ concerns about the very high exposure to Greece of its commercial and financial sector. The communist-led government’s failure to keep public expenditure under control during the world financial crisis of the past three years has greatly exacerbated the problem.

Then, on July 11, came the explosion that destroyed Cyprus’s largest power station, killed 13 people, knocked out half the country’s power supply and disrupted the tourism industry on which the island’s economy heavily depends. The bill for this accident may rise to as much as €2.4bn, or 14 per cent of annual economic output.

Cyprus is sure to receive European Union aid to cope with the aftermath of the disaster. Its banks are flush with the deposits of non-residents, which could in theory be drawn upon in a funding crisis. The biggest problem is the government’s refusal or inability to undertake the fiscal and structural reforms essential for long-term survival in the eurozone. In this sense Cyprus is even more remiss than its struggling Mediterranean neighbours.

Cyprus, Iceland, and German bail-out fatigue
by Ambrose Evans-Pritchard - Telegraph

Credit default swaps (CDS) on Cyprus debt have jumped to 674 basis points, the sort of level that preceded the EU rescues of Greece, Ireland, and Portugal. The CDS were trading in the 300s earlier this month, according to Markit. Yesterday’s 2-notch downgrade by Moody’s to Baa1 – due to "fractious politics" and exposure to Greece – has come as a nasty surprise to markets and the EU authorities. It should not have done.

Cyprus has been sailing close to the wind for several years. The current account deficit reached 17.5pc of GDP in 2008 (IMF data), and is still high. The budget deficit is running at over 7pc this year. The country has lost competitiveness since pegging its currency and then joining EMU, much like Greece. But there is another twist. Its banking system is "roughly nine times GDP", according to Chris Pryce at Fitch Ratings. This is €157bn. The figure drops to €96bn of GDP, or 550pc if foreign banks are excluded. Roughly 40pc of exposure of the biggest Cypriot banks is to Greece.

I don’t wish make some mechanical linkage between bank-to-GDP ratios and underlying risk (the devil is in the details) but this over-grown banking sector has shades of, well, Iceland. The Russians have used Cypriot banks as their conduit into the EU. "This has been a constant reliable source for Cyprus banks, up until now," said Mr Pryce. "If the Russian deposits stop coming, Cyprus still has the ECB. This is the difference between Cyprus and Iceland," he said.

The exposure of the Cypriot banks to Greek government bonds is 33pc of Cyprus’s GDP. The bigger worry is the entanglement of Cypriot banks in the Greek economy. On top of this, an explosion has knocked out the main power station at Vasikilos and cut 45pc of country’s power supply, though imported generators are covering some of the slack.

Cyprus is of course small beer with just 870,000 people and a GDP of €17bn. Clearly the EU can help if needed. The risk is political. Should a 4th eurozone country emerge from out of the blue and ask for a bail-out, it will test the patience of Slovakia, Finland, the Netherlands and Germany yet nearer to breaking point. Exactly where that breaking point lies is the great unknown.

Berlin is hardly sympathetic to Cyprus. There was gentleman’s agreement when Cyprus was let into the EU in 2004 that it should resolve the dispute with the Turkish part of the island. (I might add that Greece was truculent in the talks, threatening to block Poland’s EU accession unless Cyprus was let in).

The Turkish North voted for a united island, but the accord was in essence violated by President Tassos Papadopoulos when he took office. He threw his weight behind the `No’ campaign in the Greek side of the island and helped sabotage the agreement. This is not forgotten in EU circles. This betrayal may now haunt Cyprus if it needs German help. As for Greece, another tear I am afraid.

The European Commission has published more details on the new bail-out settlement. It shows that Greece’s debt will be cut by €26bn, or 11.6pc of GDP. But once a complicated "credit enhancement measure" worth €35bn to secure the AAA rating of the bail-out bonds is included, the overall debt will go up. "There will be an increase in Greek debt of €9bn (4pc of GDP)," said Jürgen Michels from Citigroup. "All in all, the impact on solvency is pretty small,. The debt will still be around 160pc or so next year, under our calculations."

If so, I don’t see how Greece can possibly avoid a third rescue – which has been ruled out categorically by Eurogroup chief Jean-Claude Juncker – or a bigger default, or something more drastic.

The interesting twist in Standard & Poor’s latest Greek downgrade – this time to an even lower CCC, as if it matters – was a paragraph that began: "Should Greece exit the eurozone … "

Well, well.

Greece Will Default on Debt After EU Plan Takes Place, S&P Says
by John Fraher - Bloomberg

Greece will partially default on its debt once European officials push through a plan that will see bondholders foot part of the bill of a second bailout agreed to last week in Brussels, Standard & Poor’s said.

The rating company also cut its ranking for Greece to CC, two steps above default, from CCC, according to a statement published in London today. The outlook on the debt is negative. "The proposed restructuring of Greek government debt would amount to a selective default under our rating methodology," S&P said. "We view the proposed restructuring as a ‘distressed exchange’ because, based on public statements by European policymakers, it is likely to result in losses for commercial creditors."

EU leaders agreed last week that bondholders will contribute 50 billion euros ($72 billion) to a new rescue package, with euro-region governments and the International Monetary Fund putting up a further 109 billion euros.

The cost of insuring against a default by Greece was at 1,695 basis points today, implying a 76 percent chance the government will fail to pay its debts within five years. The price of the contracts soared to a record 2,568 basis points on July 18, when the probability of default approached 90 percent, according to CMA.

"There hasn’t been a big shock to the market as it’s mostly water under the bridge," said David Keeble, head of fixed income strategy at Credit Agricole Corporate & Investment Bank in New York. "I think the market is prepared for the next step, which is selective default and which should happen in a month or so. It will be interesting to see what rating Greece will be assigned after the SD phase."

Seeking a Path out of the Crisis in Portugal
by Alexander Jung - Spiegel

After living beyond its means for decades, Portugal is now feeling the full brunt of the crisis. The government is responding with a brutal austerity package. But savings alone won't do the trick -- the country needs to find ways to expand industry and make itself more attractive for investment. The good news is that positive models already exist within its own borders.

The air smells salty at Cabo da Roca, about 30 kilometers (19 miles) from Lisbon, the westernmost point of mainland Europe. A lighthouse is perched on the cliffs, high above the roaring sea. The sign in front of it reads: "The End of Europe." These words sound strangely prophetic at the moment.

On the way there, a two-lane bike path hugs the coastline for several kilometers between Cascais and Guincho. Special streetlights spaced only 50 meters apart illuminate the brownish red, special asphalt at night. But cyclists are rarely to be found along this route, even during the day, because the wind is simply too strong.

The luxury bike path is a reminder of better times, of the years when the Portuguese were still able to draw on unlimited resources. They built the Colombo in Lisbon, Europe's largest shopping center at the time. They also built state-of-the-art football stadiums and many new roads, including 2,700 kilometers of motorways in two decades, many with six lanes -- which are often completely empty.

Many things in Portugal are oversized, and the dramatic consequences of this exorbitant lifestyle are now manifesting themselves. The country had to resort to the euro zone's bailout fund in April, but it only provided Portugal with a brief respite from its financial woes.

The gravity of the situation became abundantly clear when the Moody's rating agency, after questioning whether the country could still service its debts, downgraded Portugal's government bonds to junk status earlier this month. Portugal has overreached financially, and it will have trouble coping with the crisis. Could the euro zone be facing a second Greece?

Brutal Austerity Measures
The new center-right government headed by Prime Minister Pedro Passos Coelho assembled a brutal austerity package, which includes reductions in healthcare benefits and a pay cut for government employees. Two weeks ago, Coelho expanded the list of painful cuts even further, after new holes in the budget had opened up. Before that, the prime minister had announced that the Portuguese people would have to prepare themselves for "two difficult years."

Margarida Sá Pereira, a businesswoman in Lisbon, is getting ready for leaner times. Her family has sold candles on Rua do Loreto since 1789. The shop sells egg-shaped candles around Easter and candles shaped like pine trees at Christmas, each handmade with the finest wax. Sá Pereira, a petite woman with conspicuous glasses, stands behind the counter. Wood-paneled display cases reach to the ceiling on both sides of the shop. As the minutes pass by, not a single customer enters the shop.

Customers have been holding on to their money for months, says Sá Pereira, and now the new government wants to tax Christmas bonuses, of all things. Sá Pereira, who makes at least a quarter of annual sales in the days leading up to the holiday, says: "Christmas will be very difficult for us."

Portugal Has Lived Beyond Its Means for Decades
The Portuguese have lived beyond their means for decades, but they were also misled into doing so. At first, the European Union tempted Lisbon with generous aid programs. Since Portugal joined the union in 1986, Brussels has sent about €55 billion ($79 billion) to the country. Then the introduction of the common currency gave the economy another boost.

Suddenly Portugal was enjoying the same access to credit as major countries like Germany and France. As a result, its people became accustomed to fast cars and fancy apartments, all paid for with borrowed funds. But Portugal's apparent affluence was deceptive, because it bore no relationship to the country's real economic strength.

Now the Portuguese have no choice but to save money in every possible way. Even smokers have cut back, as evidenced by a 20-percent decline in tobacco tax revenues in May. Signs in shop windows that read "Liquidição total," or total liquidation, especially in smaller communities, are another indicator of decline.

The country is deep in a state of crisis, but it seems foreseeable that the worst is yet to come. Interest rates are going up, borrowing is getting more expensive, banks are lending less money, companies have stopped investing, some are going under as a result of the credit crunch, and the unemployment rate continues to rise. Surprisingly enough, there is hardly any sign of resistance in the country. Many Portuguese are simply shocked.

Unlike the Greeks, the Portuguese did not become involved in questionable business practices. Their banks did not issue nearly as many high-risk loans as their Irish counterparts. And a real estate bubble did not develop in Portugal, at least not to the same extent as it did in Spain. But now the Portuguese are in the same boat as several other ailing European economies. They are hopelessly in debt and their economic future seems questionable at best. Concerned citizens are asking themselves how this could have happened.

Portuguese Victims of Globalization
One answer can be found in Figueiró dos Vinhos, an attractive town in a hilly and densely forested landscape near Coimbra in central Portugal. Gerry Weber, a German clothing company, built a factory there in 1993, where about 160 workers, all of them women, produced jackets and trousers. The women were paid low wages and Gerry Weber benefited from EU subsidies, with Brussels paying about half of the roughly €3 million ($4.35 million) the company invested in the plant.

The factory suddenly closed its doors 10 years later. Local council member Jorge Domingues, the right-hand man of Figueiró's mayor, remembers how surprised they were by the news of the plant closing. "We were all extremely disappointed," he says.

Domingues is standing in front of the entrance to the factory, a white, two-story building. The blinds are lowered and there is a "For Sale" sign in the window. The German managers used to stay in a top-floor apartment, says Domingues, pointing up at the building. In 2003, they decided to move production to Romania, where costs were 40 percent lower than in Portugal. The women of Figueiró became victims of globalization.

Many Portuguese have suffered similar fates in recent years, as one international company after another shut down its factories in the country. Some 50,000 jobs were lost in the shoe industry alone. One in four of the jobs lost between 2003 and 2006 was blamed on outsourcing, particularly to Eastern Europe and the Far East. By comparison, outsourcing was responsible for only about seven percent of jobs lost in Germany.

During this time, Portugal failed to climb further up the ladder of economic development, as the Southeast Asian Tiger economies had done previously, transforming themselves from makers of cheap, mass-produced goods to efficient suppliers of high-tech products. Instead, the Portuguese economy has been treading water for years, but without keeping pace with rapidly rising incomes. As a result, unit labor costs have increased by more than one-third compared to German levels since 1996.

In other words, Portugal is too expensive for what it is capable of producing.

Part 2: A Country that Produces Too Little and Consumes Too Much
There are, of course, exceptions. Volkswagen operates a successful plant in Palmela, south of Lisbon, where about 3,000 workers assemble the carmaker's Sharan, Eos and Scirocco models, almost exclusively for export. VW has worked out flexible rules with the works council, a powerful employee-elected panel that represents the interests of workers, that permit the company to eliminate up to 22 working days a year during an economic downturn.

But there is so much work at the moment that the period in which the plant shuts down for summer vacation has been reduced this year from three down to two weeks. The Palmela plant generates about €1.6 billion in annual revenues for VW, which corresponds to one percent of the entire country's gross domestic product. That makes the plant, which is on the small side by VW standards, the biggest foreign investment in Portugal.

"We are at the eye of the storm," says Jürgen Hoffmann, chief financial officer of VW's Portugal operation. His words also describe the central problem of the Portuguese economy, which lacks a broad industrial base. It needs many more companies to invest in the country and produce goods for export. Portugal's gross domestic product of €166 billion is roughly equal to the combined sales of two major German companies, automaker Daimler and electronics giant Siemens. Portugal's problem is that it produces too little and consumes too much.

A Lack of Competition and Entrepreneurship
This imbalance is partly attributable to historic circumstances. The country lacks a tradition of competition and entrepreneurship. The government has assumed a dominant role for generations, a legacy of the right-wing dictatorship that came into power in 1936 as well as the country's Carnation Revolution in 1974, which brought an end to decades of authoritarian rule. Little remains of the daring that characterized the discoverers of the world's oceans centuries ago.

Today Portugal is a country with an oversized bureaucracy. Of its labor force of 5 million, some 750,000 work in the public sector, and they are well paid. According to the Organization for Economic Cooperation and Development (OECD), salaries for Portuguese civil servants are "far above" incomes for comparable work in the private sector.

Nevertheless, many government agencies are inefficient and ineffective. The processing of tax returns is often delayed, government offices are chronically late in paying invoices and the permitting process can be a waiting game. For example, it takes an average of 287 days to complete all the formalities required to build a warehouse in Portugal. The OECD average is 157 days.

The new government has declared war on inefficiency, at least to the extent of its abilities. It aims to reduce the backlog of pending cases in the court system, but even the targeted new waiting period would still amount to two years. This nonchalant or even negligent approach is also evident in the private sector.

A brochure for potential investors published by the Bavarian Foreign Trade Center points out that in Portugal senior managers "normally arrive at work between 9:30 and 10:00 a.m." Besides, the brochure continues, lunch and the midday break are "sacred to the Portuguese." Its advice to potential investors in Portugal? "Don't try to interrupt the customary routine between 1 and 3 p.m."

A Dearth of Qualified Workers
Another deterrent for some investors is the lack of qualified new workers. Only 15 percent of the Portuguese working population has attended a university. The EU average is twice as high. In addition, many young people drop out of school. According to a survey by the German Chambers of Commerce Worldwide Network (AHK), many German companies in Portugal are not satisfied with the qualifications of entry-level employees. Manager Paul Van Rooij drew what he felt were the necessary conclusions.

Van Rooij manages Gametal, an automotive supplier that is part of the multinational Kirchhoff Group, based in the western German city of Iserlohn. Workers at the Gametal plant in Ovar, south of Porto in northern Portugal, produce metal parts for companies like Volkswagen. They operate heavy presses that plunge onto pieces of sheet metal, molding them into parts as if they were sticks of butter. The impact is so great that the floor shakes at every downward stroke of the presses.

A few temporary offices in containers were recently installed at one end of the building, where Van Rooij has set up a small tool-making school. There were 20 young trainees at first. The program has been so successful that some of the graduates have already been lured away by other companies. Many years ago, AHK also established a dual system based on the German model, which is still an unusual approach in Portugal.

"Industry is not considered sexy here," says Van Rooij, seeking to explain the lack of interest in industrial jobs. Even banks have sometimes shown little interest in working with manufacturing companies, after years of having financed primarily retail projects, such as shopping centers. It's no surprise that Portugal lacks solid industries capable of producing exportable products. But what should those industries be? The answer that António Rios de Amorim proposes sounds deceptively simple: "This country must build on what it does best."

A Model for Portugal
Amorim, 43, is the chairman of Corticeira Amorim, the world's largest producer of natural cork. One in four cork stoppers comes from his factories, which produce about 3 billion units a year. The cork bark comes from southern Portugal, where it has long been peeled from the trunks of old cork oaks. The procedure is repeated once every nine years. At the company's main plant, in a northern village near Porto, the corks are punched out, washed and bleached.

A mural in Amorim's office, about eight meters (26 feet) wide, depicts a forest of cork oaks. What is unusual about the image is that the trees are planted in neat rows. When Amorim became chairman of the company in 2001, screw caps and glass stoppers were threatening the dominant position of cork stoppers. To confront the challenge, he reorganized the family operation.

Amorim expanded the business into emerging winemaking countries like Chile, Australia and New Zealand, thereby enlarging his sales base. He invested in research to determine what makes up the unique taste of cork. Most of all, Amorim expanded the company's product line to include the use of cork soundproofing for floors, wall coverings, seals for oil pans in cars, insoles and even heat shields in spaceships. As a result of his restructuring, the company recently had the best year in its history -- in the midst of a nationwide downturn.

Amorim believes that his approach could serve as a model for the entire country, and that Portugal should identify and build upon its original strengths. "We have so many treasures," says Amorim. "We just have to unearth them."

Austerity measures alone will not get Portugal back on its feet -- or Greece, Ireland or Spain, for that matter. One approach to jumpstarting the economy would be to define the wood and paper industry as a productive core of the economy, especially given that a third of the country is forested. In the shoe industry, a few companies have already shifted their focus to the production of high-quality designer goods. "Portugal must achieve higher productivity by specializing in quality products," the OECD economists recommend in their report on Portugal.

The economists have also identified additional potential in tourism. In Portugal, the tourism sector is only half as productive as it is in France, for example, with too many budget options and weak capacity utilization. A few years ago the chief economist at the International Monetary Fund, Olivier Blanchard, came up with the idea of establishing Portugal as a retirement destination -- the so-called Florida model.

Jorge Domingues, a city council member in the former textile manufacturing center of Figueiró, envisions a similar strategy. He hopes to attract tourists to the region, which is blessed with pine forests and waterfalls, preferably for the long term. Domingues, who estimates that about 100 foreigners already have vacation homes nearby, says: "Even an Australian has settled here."

US corporate cash hoard in the trillions: Moody’s
by Tim Kiladze - Globe and Mail

U.S. non-financial companies sat on a whopping $1.2-trillion (U.S.) in cash and short-term liquid investments at the end of 2010, according to Moody’s. That’s up 11 per cent from the $1.1-trillion at the end of 2009

These cash levels are probably only going to increase. Moody’s review ends at December 31, at which Apple Inc.’s cash and short-term investments balance totalled $60-billion. When it reported quarterly earnings two weeks ago, that balance had climbed to $78-billion.

Because the value of liquid assets is so high, U.S. companies’ debt-to-cash ratios hit a five-year low of 3.06 times in 2010, despite extremely low interest rates and big corporate debt issuance, particularly last summer.

Moody’s estimates that about half of the cash balances, or $600-billion, are housed overseas. (Moody’s was able to calculate this because some of the biggest firms actual disclose their overseas totals, while others disclosed it in private to Moody’s.) The value makes sense because international profits have been driving this quarter’s earnings performance and firms have been keeping this money off-shore so that they don’t have to pay U.S. tax rates. (Earnings from foreign subsidiaries aren’t taxed until they are repatriated to the U.S.)

Much like any wealth distribution, a large chunk of the cash hoard is held by a relatively small number of companies. Moody’s calculated that the 20 top holders of cash account for $488-billion of the $1.2-trillion total. These firms include the likes of Apple Inc., Microsoft Corp. and Pfizer Inc. Technology firms held the most cash than any other U.S. industry.

But really, all firms are at fault, because corporate profits have been widespread. "Between 2009 and 2010, our corporate universe recorded an 11.7 per cent increase in revenues, a 45 per cent increase in operating income and a 24 per cent increase in funds from operations." All of this with a 9.2 per cent unemployment rate south of the border.

Banks Clash Over Foreclosure Tab
by Dan Fitzpatrick, Nick Timiraos and Ruth Simon - Wall Street Journal

U.S. banks trying to negotiate a settlement over the home-foreclosure mess have hit a new hurdle: They are squabbling over how to split the tab.

The lack of a deal so far among the nation's largest home-loan servicers has already depressed bank stocks, and an extended impasse could further spook investors. "As time goes on, banks will lose the PR battle," said Paul Miller, banking analyst with FBR Capital Markets. The terms of a settlement, he said, are less important than getting it done. "They need to get everything behind them."

As federal and state officials prod banks toward a multibillion-dollar deal to atone for a host of irregularities in foreclosing homes around the U.S., Wells Fargo & Co. has told government officials it should pay less than Bank of America Corp. or J.P. Morgan Chase & Co., according to people familiar with the situation.

The behind-the-scenes infighting has delayed a resolution and could prolong the months-long uncertainty over the ultimate cost of ending one of the biggest controversies stemming from the financial crisis.

Negotiations already have dragged on past the mid-June target set by U.S. officials, despite shareholder pressure on banks to reach a deal. Settlement talks with Bank of America, Wells Fargo, J.P. Morgan, Citigroup and Ally Financial Inc. began in March and include a mix of all 50 state attorneys general, the Treasury Department, Justice Department and Department of Housing and Urban Development.

The latest disagreement among banks is a contrast to the largely unified public stance taken by financial firms as they work to put the foreclosure woes behind them. Wells Fargo contends it should be rewarded for having fewer risky or delinquent mortgages than the other two, people familiar with the matter said. Citigroup Inc. also has told regulators the structure of a settlement should reflect differences between financial institutions, claiming it should pay less because of its stronger controls on foreclosure practices, these people said.

The disagreement among banks is one of the issues holding up the process. Other sticking points include whether to release financial institutions from other types of mortgage-related claims. Banks are pushing for broad protections, but that move is running into opposition from state attorneys general. All sides have agreed to a framework that would govern how banks meet their obligations once a deal is reached. Those include principal reductions on certain mortgages, forgiveness of second-lien loans, restitution to borrowers and dealing with foreclosure-related blight. A person close to one of the banks said remaining differences are narrowing.

The furor exploded last fall when banks were forced to suspend home seizures amid allegations that employees routinely signed off on foreclosure documents without personally reviewing underlying details. U.S. regulators later found deficiencies and shortcomings in paperwork procedures, as well as violations of state law, among 14 servicers. Bank of America, Wells Fargo, J.P. Morgan, Citigroup and Ally Financial initially offered to pay $5 billion, but government officials are pressing for a settlement of $20 billion to $25 billion, according to people familiar with the matter.

At first, the banks worked hard to show unity in negotiations with regulators, holding private conference calls to map out their response and possible areas of compromise. As the discussions advanced, some banks began arguing for different treatment compared with other banks.

Citigroup is pushing to keep its part of any settlement at about $1 billion, said people familiar with the situation. Wells Fargo, based in San Francisco, is discussing a range of $4 billion to $5 billion, trying to stay as close to $4 billion as possible, another person said. Bank of America has argued for a speedy resolution, claiming a deal will get the U.S. housing market back on track. "Our portfolio is different from others, and we are very proud of the prudence we had," John Stumpf, Wells Fargo's chief executive, recently told investors. "We tell the Wells Fargo story in plain English when we have those discussions" with state attorneys general and other officials, he added.

About 7.2% of the $1.8 trillion in mortgages serviced by Wells Fargo are at least 30 days past due or in foreclosure, according to industry newsletter Inside Mortgage Finance. That compares with a delinquency rate of about 13% at Bank of America, which services $2.04 trillion in mortgages.

In June, though, the Obama administration said it would withhold millions of dollars in fees for reworking troubled mortgages from Bank of America, J.P. Morgan Chase and Wells Fargo because of poor performance in the government's loan-modification program. Last week, Wells Fargo agreed to pay an $85 million civil penalty in response to allegations it steered thousands of potential prime-mortgage borrowers into more-costly subprime loans.

Friction also has surfaced on the use of widespread loan-principal reductions to help borrowers. Bank of America has privately signaled it is willing to consider write-downs in cases in which they would be less costly than foreclosures. Wells Fargo has indicated it is willing to consider principal reductions, but executives remain opposed to any write-downs of loans held by other investors, these people said.

Tensions between U.S. and state officials over how quickly to finish the deal also are a potential snag. Some state officials and HUD have pushed for a deal that offers immediate aid to troubled borrowers. But some state attorneys general have publicly expressed concerns about any deal that would give banks broad relief from additional legal claims. On Monday, Massachusetts Attorney General Martha Coakley told local officials in a letter she "will not sign on to any global agreement with the banks if it includes a comprehensive release regarding securitization" of loans into mortgages securities and the conduct of a mortgage-loan middleman.

The American Dream slips even further out of reach
by Nin-Hai Tseng - Fortune

A key tenet of the American Dream is that each generation will do better than the last. That principle was severely shaken by the Great Recession. Most of the blame rested on the housing crisis, which forced families out of homes they couldn't afford. Now a new study suggests there's another measure of well being that's keeping Americans from fulfilling the dream.

The typical American family earns more today than it did decades ago. But that's mostly because parents are working longer hours -- not because their wages have risen that much more -- according to a report from the Brookings Institution's Hamilton Project.

Households today are struggling with an unemployment rate hovering above 9%. And those lucky enough to have jobs aren't free of challenges. Median wages for two-parent families grew 23% since 1975, according to the study. But in 2009, two-parent households worked 26% longer than those two and a half decades ago. The figures reflect more women entering the workforce, but it also implies that wages haven't increased as much as the rise in worker hours would suggest.

Those numbers capture only part of the challenge as the traditional nuclear family breaks up. A drop in the marriage rate has resulted in a doubling of single-parent households over the past three and a half decades. In those households, annual hours have risen 53% since 1975, while earnings growth has grown by 69% during the same period. Nevertheless, at single-parent households where the financial burden tends to fall on one earner, median earnings are about $16,500 -- which is less than one-fourth that of a two-parent family.

The Brookings study echoes the conclusions of other research that show American workers are producing more without a corresponding rise in wages. But it also highlights deeper problems that workers are facing down the road. The crash of the real estate market plus the deep recession that followed forced many out-of-work and heavily indebted families to reexamine the notion of the American Dream. And future generations are wondering if it's even a possibility.

Gluskin Sheff Economist David Rosenberg notes in a recent report that unlike baby boomers who often viewed homeownership as a retirement asset, the larger group of 82 million Millennials that followed are more apt to rent than buy.  And they'll likely be paying for the shambles of the real estate market for a while. The 35% spiral in home prices nationwide over the past four years has constrained consumer demand, stalling companies from hiring more employees. So for future generations, stagnant wages won't be the only big issue; they'll have to find a job first.

Deteriorating Transportation Infrastructure Could Cost America $3.1 Trillion
by Matt Sledge - Huffington Post

New tires add up. That's the finding of a report issued Wednesday by the American Society for Civil Engineers, which tallies up the cost of our decaying surface transportation infrastructure, from potholes to rusting bridges to buses that never come.

The engineers found that overall, the cost of failing to invest more in the nation's roads and bridges would total $3.1 trillion in lost GDP growth by 2020. For workers, the toll of investing only at current levels would be equally daunting: 877,000 jobs would also be lost. Already, the report found, deficient and deteriorating surface transportation cost us $130 billion in 2010.

By and large those costs would not come from the more dramatic failings of America's transportation system -- like the collapse of the I-35W Bridge in Minnesota -- but more mundane or even invisible problems. The minivan that hits a pothole chips away at a family's income. The clogged highway that drains away an extra half hour of a trucker's day also drives up the cost of shipping for businesses.

Congestion, the report found, is of particular cause for concern. Already, 40 percent of urban interstates have capacity deficiencies. Currently, that costs us $27 billion a year in lost time and other inefficiencies wasted on the roads. By 2020, that number could grow tenfold, reaching $276 billion a year.

The civil engineers are, by their own admission, a biased party -- they stand to gain the most from renewed investment in infrastructure -- but they paint a picture of an infrastructure shortfall that would have ripple effects far and wide through society.

Companies, the report estimates, would underperform by $240 billion over the next ten years without additional investment. Exporters, which would have trouble moving goods to market, would send $28 billion in trade less abroad. The cost to families' household budgets, the report suggests, would by $1,060 a year. Underscoring the wider appeal of ASCE's argument, the report received the backing of both labor and business leaders.

"Today’s report from the American Society of Civil Engineers further reinforces that the U.S. is missing a huge opportunity to ignite economic growth, improve our global competitiveness, and create jobs," said Tom Donohue, president and CEO of the U.S. Chamber of Commerce.

Richard Trumka, the AFL-CIO president, said, "with a modest increase in investment, we can rebuild a strong economy where business can thrive and workers can afford a place to live, raise a family, take an occasional vacation, pay for their children’s education and have a dignified retirement." The ASCE claims the answer to the transportation problem is simple: Invest more, and quickly. "The problems facing our nation's infrastructure are widely acknowledged and well understood," said Andrew Herrmann, the president-elect of the ASCE.

But that doesn't mean Congress is rushing to fix them. Re-authorization of the transportation bill that pays for most of our highways has stalled. The House Republican outline for a bill would slash one third of transportation funding. The idea behind cutting those funds is that private enterprise could fill the gap.

Further, gas taxes revenues, which have traditionally been used to pay for transportation funding, are falling because they aren't tied to inflation and more people are switching over to fuel-efficient cars. For conservatives, some sort of new tax is verboten, even though they might appreciate infrastructure's benefits to business.

But even the Republican chair of the House Transportation Committee is not satisfied with his transportation plan. He said he was forced to limit his spending plan because of the House GOP leadership's allergy to tax revenue. "They wouldn't vote on a Mother's Day resolution if it had extra spending on it," Rep. John Mica (R-Fla.) told the Wall Street Journal.

David Goldberg, the communications director of Transportation for America, said part of the problem with finding new government funding for transportation lies with the fact that there are fewer new roads to be built. Much of what we need to do lies with fixing old highways. "Maintenance and repair and upgrades are not as sexy as ribbon-cuttings on new projects," Goldberg said, "And there's a lot of political pressure many times to build new projects."

But beyond that, Goldberg would also like to see expanded access to mass transit. One surprising result of the ASCE report was that cost of deficiencies to Americans in bus transit alone would add up to $398 billion by 2020.

Scott Bernstein, the president of the Center for Neighborhood Technology, said that while "the general argument that we need to not lose any more ground is sound," we should look more closely at what our infrastructure spending gets us. "I think they missed the opportunity to talk about what people actually spend on transportation," Bernstein said. He said he thought inadequate spending on infrastructure, especially on mass transit, hurts poor families disproportionately. "Simply spending it on maintaining highway capacity isn't likely to give people much more of a deal," Bernstein said.

The new report is agnostic on where we should direct new transportation money towards, if we ever decide to increasing spending at all. But ASCE does give a nod towards high speed rail, saying that:
"Most of America's major economic competitors in Europe and Asia -- including Japan, Germany, France, Spain and Great Britain, as well as rapidly developing and developed countries such as China, Taiwan and South Korea -- have already invested in and are reaping the benefits of improved competitiveness from their intermetropolitan high speed rail systems. Simply continuing to invest in the nation's existing transportation infrastructure may not be enough to maintain its standing in the global economy in the long run.

So far, Goldberg said, we're nowhere near looking at problems like that. "The big question is, can we come to any kind of agreement about what is worth investing in? And can we do it in a timely enough way to avoid the bills the engineers' report warns us of?" Of course, decaying roads and bridges don't make everyone worse off. One of the report's few bright spots: The future looks good for auto repair shops, which are expected to see increased demand as our roads get worse.

California Counties Reel From Tax Hit
by Justin Scheck - Wall Street Journal

Declining home prices are starting to slam California harder than the rest of the nation, in part due to a state law that sets a ceiling—but no floor—on property taxes.

The toll is evident here in Calaveras County, a largely rural area about 100 miles east of San Francisco. Over the past three years, it has seen among the biggest property-tax roll declines of any California county, with the total value of taxable properties down about 5% from last year—and 18% over the past three years—to $5.67 billion. Statewide, assessed values declined 1.8% last year from a year earlier, according to state data.

Calaveras's shrinking property taxes have resulted in cuts to the sheriff's department and public-health services, as well as an effort to cut 10% of the county's budget for the coming year. The tax drop also has pitted the county assessor, who has lowered taxes by re-evaluating home prices, against the head of the county board of supervisors, who said the reassessments have been too aggressive. "We're getting cremated" by the decline in property taxes, said Tom Tryon, chairman of the board of supervisors.

Calaveras's situation shines a spotlight on the unintended consequences of California's property-tax law. While many counties nationwide have offset property-tax declines by raising tax rates, a 1978 California law dubbed Proposition 13 prohibits that practice in the Golden State. The law caps property taxes at about 1% of a home's value and forbids major tax increases unless a home is sold or rebuilt, though it permits taxes to go down if a home's value drops.

As a result, while local governments in Washington, Maine, Hawaii and elsewhere recently raised property-tax rates to compensate for home-value declines, California doesn't have that option. It can take years for a California county to recover from a short-term decline in property-tax revenue, because tax revenue doesn't go up until home prices rise and many properties are sold.

Nationwide, property taxes make up about 45% of local-government revenue, according to Nathan Anderson, an economics professor at the University of Illinois. They have become a pivotal source of funding for local governments as other revenue sources dried up, said Mr. Anderson, who studies property taxes.

Bob Stern, president of the Center for Governmental Studies, a nonprofit and nonpartisan think tank in Los Angeles, said there were "pros and cons with Prop 13." While the measure has succeeded in its goal of protecting senior citizens on fixed incomes from big tax increases due to rising real-estate values, he said, people didn't expect California property prices would drop for a long period, and therefore didn't foresee the problems in counties suffering from declining property values.

Counties across the state are now grappling with Prop 13's fallout. Central California's Stanislaus County saw its property-tax roll—the cumulative value of assessed properties—fall 4.7% this year and 21% over the past four years. It levied $447 million in property taxes last year, down 11.6% from two years earlier.

In San Diego County, property-tax levies in 2010 fell by more than $100 million to $3.96 billion—the first year-over-year decline in more than a decade. In Calaveras, declining property values and property taxes have put Leslie Davis in the hot seat. Since being elected the county's tax assessor last year, she has been fielding calls from residents who said their taxes were too high because their homes were assessed at prebust values.

Under state law, assessors are supposed to re-evaluate homes to make sure they are being taxed at a fair rate. So Ms. Davis sent employees to re-evaluate home prices, which generally had gone down.

That caused consternation among other officials, who were struggling with state budget cuts and a county unemployment rate of more than 15%. "Budgetary woes continue to plague local agencies that depend on direct tax support for their operations," the county's civil grand jury, an investigative arm of the court system, wrote in a June report.

The county's board of supervisors, led by Mr. Tryon, said it will have to cut services such as sheriff patrols. He has criticized Ms. Davis's reassessments, saying they are too aggressive. "All we live on in this county is basically property tax," Mr. Tryon said, adding that assessors "have a lot of discretion, and [Ms. Davis has] used hers in a way that's devastated the county." Ms. Davis said she is just doing her job. "The law requires me to reassess," she said.

States Miss Pension Targets by 50% Even With Private Equity
by Martin Z. Braun - Bloomberg

In the last decade, as a wave of baby boomers began retiring, America’s biggest state pension systems earned less than half what they needed to keep up with promises made to millions of graying civil servants.

The state of Washington’s 3.92 percent return for the 10 years through June 30, 2010, after fees, was the best in a Bloomberg survey of state pensions with more than $20 billion in assets. That was nowhere close to the average yearly gains of as much as 8 percent that fund managers and public officials count on for meeting obligations to retirees. "To assume that the median plan will reach 8 percent given this environment, that’s optimistic to say the least," said Karl Mergenthaler, an executive director in JPMorgan Chase & Co.’s securities services group in New York. "Public plans have an incentive to maintain their expected rate where it is. The risk is that they’ll overreach for returns."

The last decade is forcing public pensions to re-evaluate the projected returns that determine how much money taxpayers and retirees need to pour into retirement funds. Some systems such as New York, Rhode Island and the California State Teachers Retirement System have reduced their assumptions. It’s a tough call because lowering projected gains can widen funding gaps, forcing lawmakers to put even more money into the programs.

Complicating the issue of what returns to expect are the extraordinary reverses of the last 10 years, including the Internet stock bubble, the financial crisis of 2008 and the worst recession since the Great Depression. Returns over 30 years still average more than 8 percent, according to the National Association of State Retirement Administrators. And in the 12 months after June 2010, markets and fund assets surged.

Largest Funds’ Gains
For the fiscal year ended June 30, the California Public Employees’ Retirement System -- the nation’s largest -- said it gained 20.7 percent, and the California teachers program, the second-largest pension plan, 23.1 percent. The third-largest, the New York State Common Retirement Fund, returned an estimated 14.6 percent in the fiscal year ended March 31, according to the state comptroller.

Even though state pension funds posted near-record preliminary returns for the last fiscal year, their 10-year gains are still less than 8 percent. Calpers’s 10-year return increased to 5.36 percent last year from 2.6 percent the previous year, and the California teachers’ fund, to 5.7 percent from 2.5 percent.

The median state pension fund will achieve an annual return of 6.5 percent in the next 15 years, according to a February 2011 study by Wilshire Associates, the Santa Monica, California, investment adviser.

Alternatives Beat Stocks
In outperforming other public funds over the last decade, Washington’s system benefited from investments in real estate and private-equity placements. Private-equity pools may invest borrowed funds, which can amplify returns and losses, and their holdings are often opaque. Calpers cited gains on private-equity investments for its 2011 gains. "It’s an illiquid, high-risk strategy," said Tim Friedman, head of communications at Preqin Ltd., a London-based private-equity research firm. "You can lose everything."

Washington’s program, with $52.7 billion of assets as of June 30, 2010, is setting the pace as other systems are boosting private-equity investments, according to consultants. Pensions are also cutting their holdings of U.S. stocks and buying assets in developing countries such as China, India and South Africa.

Political Backlash
Three of the top five performing funds -- Washington, Oregon, and the Pennsylvania teachers fund -- had more than 30 percent of their assets in private equity and real estate, according to data compiled by the state retirement administrators’ group. Four of the five worst performers -- Maryland, Arizona, the California teachers and Georgia -- had more than 50 percent of assets in publicly traded equities.

State pension funds increased average allocations for private equity to 8.8 percent in 2010 from 3 percent in 2000, Wilshire found in its February study. Meanwhile, the average allocation to U.S. stocks by 126 state pensions declined 13.9 percentage points since 2000.

Retirement funding spurred a political backlash against public workers this year. The meager returns after years of deferred taxpayer contributions magnified funding shortages, forcing legislatures and city councils to divert more money to the pensions. This left less for public services. Adding to the pressures facing pensions, government workers are accelerating retirements as state budget crises have led to salary cuts. Governors in Wisconsin, New Jersey, Ohio and Florida have attacked unions.

Funding Gap
A quarter of the 363 human resources managers for state and local governments reported a rise in such departures in a 2011 survey by the Center for State and Local Government Excellence. Members of the baby boom generation, born from 1946 to 1964, began turning 65 this year, but many programs allow early retirements for civil servants in their 50s.

Statewide U.S. retirement programs were short $694.2 billion, or 24 percent, of having enough assets to pay future pensions at the end of their 2010 fiscal years, based on data compiled by Bloomberg as of July 15. Hawaii and Wisconsin haven’t reported and weren’t included.

Already, 14 states raised retirement age and length-of- service requirements to help close pension funding gaps, including New Jersey, Florida and Maryland, according to the National Conference of State Legislatures. Fifteen states increased employee contribution requirements in 2011, the conference said.\ State judges in Colorado and Minnesota have thrown out lawsuits by retired public employees challenging reductions to cost-of-living adjustments, ruling the increases not protected.

Performance Data Opaque
Following the money in public pensions is no easy task for retirees and taxpayers, based on the 10-year performance survey by Bloomberg. Audited results may be published online no sooner than six or nine months after a fiscal year. Returns aren’t reported consistently from fund to fund. Some disclosures may appear in annual reports, or in documents for bond sales that are unrelated to the pension funds themselves.

Bloomberg compiled data from the most recent annual reports of state pension funds with more than $20 billion in assets as of June 30, 2010. Bloomberg made follow-up calls to ensure the returns were after deduction of management fees and to request adjustments when they weren’t. The research also obtained 10- year net returns as of June 30, 2010, for funds that use a different fiscal year-end.

Two of the biggest funds whose fiscal years don’t close on June 30 -- New York’s Common Retirement Fund and Colorado’s Public Employee Retirement System -- said they couldn’t provide returns on that basis.

For the 25 programs in the survey, the median 10-year return was 3.15 percent. The pensions did beat the Standard & Poor’s 500 Index, which had an annualized loss of 1.59 percent for the period, according to Wilshire. Maryland’s fund, which stuck with conventional investments, ranked at the bottom of the survey with annual gains averaging 2.10 percent. The fund had assets totaling $31.9 billion as of June 30, 2010. It posted preliminary returns of 20.04 percent for fiscal 2011, boosting its 10-year return to 5.01 percent.

Top-Performing Washington
Gary Bruebaker was behind Washington’s decision to pour money into alternatives to stocks and bonds. He has been chief investment officer of the State Investment Board since 2001, leading a team of 30 investment professionals. The 56-year-old son of a single mother who worked 29 years for Oregon, Bruebaker says he takes his mission personally. He describes it as getting the best return for 400,000 public employees, retirees and beneficiaries at a "prudent" level of risk.

"Most of these people are people just like my mom," he says. Before taking over management of the Washington fund, Bruebaker was a civil servant in Oregon for 23 1/2 years, eight of them as deputy treasurer.

At the end of fiscal 2010, the system was fourth-best funded at 92 percent, behind those of New York, North Carolina and South Dakota, according to Bloomberg data. Alternative investments such as private-equity and hedge funds carry higher risks for retirees and taxpayers than conventional stocks and bonds. Some of the instruments are seldom traded, or not traded at all, so pensions face uncertainty about how much their investments are worth. Investing borrowed funds can amplify losses, which can be hard to limit because money placed with private-equity and hedge funds generally can’t be cashed out on demand.

Private Equity
Public retirement systems don’t disclose most details on their private-equity and hedge-fund portfolios, making it impossible for taxpayers to assess the risks. Pensions themselves may get limited information on holdings from money managers, who argue that disclosing the information could harm their strategy.

Washington was among the first public pension to invest in private equity, Bruebaker says. The state committed $13 million to a 1982 KKR & Co. buyout fund. In 2010, 26 percent of Washington’s assets were in private-equity, Bruebaker said. They’ve picked some big winners. A placement of $25 million in Menlo Ventures VII, a 1997 Silicon Valley venture capital fund that invested in early Internet companies, was valued at $117.5 million as of Dec. 31, 2010, for a 135.6 percent return, according to fund records.

Investing Advantage
Washington’s 30-year history with private equity gives it an advantage, Bruebaker says. The state has relationships with some of the best-performing funds and takes advisory seats on big investments, allowing it to work closely with the general partner, including sharing investment ideas, he said. Serving on advisory boards enables Washington to closely monitor operations and investments, the investment chief said. "Whenever they do something special, we want to be one of the first calls," Bruebaker said.

Washington’s heavier weighting toward private equity gave it a boost from 2004 to 2007, as easy credit enabled buyout funds to borrow cheaply and distribute cash to investors. In 2006, Washington’s private-equity portfolio gained 39.5 percent, compared with 8.6 percent by the S&P 500. Over the decade through June 2010, the fund’s private-equity investments returned 6.6 percent, fund records show.

Index Funds
In asset classes such as U.S. stocks where it believes managers can’t beat the market consistently, Washington has moved to funds that track an index, Bruebaker says. All of Washington’s $10.4 billion of U.S. shares, as of March 31, are in a BlackRock Inc. (BLK) fund matching all American equities, he says. The state has $7 billion of its international developed- market stocks in index funds too, according to the fund’s March 31 quarterly statement.

Washington is also increasing its allocation to emerging markets, Bruebaker says. In April, the state agreed to invest $75 million in a $750 million fund being raised by Prosperitas Real Estate Partners to invest in Brazilian property. "Growth is clearly not going to come from the U.S.," Bruebaker said. "That’s not a slap against the United States. It’s the reality of the marketplace."

Some pensions invested as much as 65 percent in stocks, helping to account for the decade’s low returns, according to Eileen Neill, a Wilshire managing director. The opening 10 years of this century was the first in 70 years in which the U.S. stock market had a negative return, she said. "If you had a lot of equity-like investments in your portfolio, you certainly didn’t get anywhere near that 8 percent return," Neill said.

Maryland had 67 percent of its assets in stocks in 2001, a figure that declined to 51 percent by the end of the decade, according to the fund’s reports. The state’s pension assets at 2010 year-end were 37 percent short of covering pensions promised to 120,247 retirees and 144,343 active vested civil servants, 10th-worst among state systems, according to Bloomberg data.

During the decade, the state’s domestic stock portfolio performed worse than the market, trailing the S&P 500 or the Dow Wilshire 5000 five years out of 10, including four straight from 2005 through 2008, the fund’s financial reports show.

Legislative Critique
The state Department of Legislative Services, a nonpartisan agency that provides research and policy analysis to Maryland’s legislature, has "repeatedly expressed concern" about the performance of the state’s active U.S. equity managers, according to a draft November 2010 presentation to the Joint Committee on Pensions.

For five straight years through 2010, passively managed funds structured to match a stock market index did better than actively managed ones, which collect higher fees, the legislative services analysts found. The percentage of the state’s domestic stockholdings placed with passive funds declined to 45 percent from about 71 percent in fiscal 2008, according to the office.

The performance of active U.S. stock managers has improved this year, beating their benchmark by 0.59 percentage point, said Robert Burd, the deputy chief investment officer for Maryland’s pension system since March. "We have confidence in our current manager lineup to add value over time," said Burd, 42, who has been with the system since 2001.

The state’s decision in 2008 to allocate money to a program targeting so-called emerging managers led to the decline in the percentage of passive managers, Burd said. Emerging managers are small firms that may be ignored by large institutional investors and often are women or members of minorities.

Maryland’s New Plan
Manager performance "only slightly explains," why the fund did worse than its peers, Burd said. "Asset allocation explains 90 percent," he said. "A lot of our peers were earlier into private equity," Burd said. It took the fund’s trustees time to get comfortable with the illiquidity, use of leverage and lack of transparency that are characteristic of private-equity funds, Burd said.

Maryland now aims to put 10 percent of its portfolio in private equity and the same share each into bonds, real estate and "credit opportunities," which include high-yield instruments and distressed debt, according to Burd. It is also allocating 15 percent to assets that will protect against inflation such as commodities, 7 percent to hedge funds and 2 percent to cash. The program is cutting the proportion for stocks to 36 percent from 51 percent, Burd said.

As Maryland diversifies its investments, it has improved expected returns while reducing portfolio risk, according to an analysis by the investment consulting group Hewitt EnnisKnupp Inc., cited in the Department of Legislative Services report.

Boom, Bust, Reaction
Maryland’s Sharpe Ratio, a measurement of the return that can be expected from each unit of risk, increased to 0.377 as of June 30, 2010, from 0.242 as of June 30, 2007, according to the report.

Although it may not appear achievable based on the last decade, public pensions should be able to return 8 percent a year on average over 30 to 40 years, said Wilshire’s Neill. Stocks have earned about 10 percent annually over the last 70 years, and will continue to produce "high single-digit" returns, she said. The debt weighing on the U.S. government, businesses and consumers will decline over the next 10 years, Neill said.

"There are regular booms and busts, and then there’s reactions," Neill said. "Ultimately, there’s always recovery, and that’s what you have to keep in mind as you’re looking out over a 10-year period."

Yes, Food Stamps are More Important than Defense
by Sharon Astyk - Casauban’s Book

On Friday, in a move that shocked, truly shocked America, President Obama said that food stamps were more important than Defense. Since this sort of prioritization is one of the fundamental differences between the US extreme right (aka Republicans) and the US center-right (also known as the Democrats), the fact that this caused an uproar among Republicans should also stun you. Republicans warn us that slashing America's defense budget until it is only double the next largest nations will cripple us, Democrats call the Republicans meanies, and everyone ignores the point.

The point is that food stamps are more important than Defense, for a fundamental reason - it is because we subsidize food stamps that we aren't having food riots like the middle east. Without food stamps, poor Americans would be starving - period. This is both bad for America's public image, but even worse for its civil function, and for its much articulated claims that we are, in fact, getting better rather than worse. Only because of food stamps and related programs can such claims seem even superficially credible.

Let's run the numbers. One in seven households in America receives food stamps, and one in six would qualify. Nearly 1/2 of all American children live in households that receive food stamps. One in eight food stamp households cares for an elder, one in five cares for a disabled non-elderly adult. One out of every five recipient households has *no* other countable income - more than 7 million Americans total.

Cancel food stamps and 7 million Americans drop to zero income. More than 2/3 of those households include children. The average food stamp recipient household owns $101 of goods and savings - total.

Food stamps also have other effects. They are the social program that is most beneficial to the overall economy, because the subsidies are spent immediately. They act as a subsidy to the larger food system - and in fact, when one out of seven Americans requires food stamps to feed their family, they act as an overall subsidy on our food system. Just like many poor nations, we are subsidizing food for a population that cannot afford it otherwise.

Given that food represents a tiny portion of most household incomes - between 10 and 12 percent - the fact that Americans cannot afford food in large numbers is significant. Much of this is attributable to the fact that medical care and food are often the only "fungible" expenses in a low income household. Cutting back on food and medicine are the only ways to get by when an unexpected expense arises. It gives us a measure of the costs of all our supposed previous "growth" - low income Americans can't afford housing *and* food, and almost no one can afford medical care.

Fundamentally, America subsidizes food for precisely the same reasons other nations do - not merely because it is the moral choice, but because it keeps us out of the streets. If Republicans don't know this yet, they'll certainly find out.