"Noon Hour. Workers in Enterprise Cotton Mill, Augusta, Georgia. The wheels are kept running through noon hour (which is only 40 minutes) so employees may be tempted to put in part of this time at machine if they wish"
Ilargi: A few days ago, in States of shock, I focused on budget problems and their political fallout in various US states. Now, a new report from the Center on Budget and Policy Priorities, New Fiscal Year Brings No Relief From Unprecedented State Budget Problems, provides a more detailed in-depth look at the issue, allowing for a few blanks and question marks to be replaced with numbers.
First though, in what may seem an introduction unrelated to state issues, here's two graphs showing decreases in US federal income tax revenues versus increases in federal spending.
And an older but no less important one depicting how fast revenues and spending diverge:
These graphs come from BusinessInsider, where Henry Blodget amusingly does the same Mish Shedlock did: they both quote John Mauldin who quotes David Rosenberg. Small world. Maybe I should quote Blodget who quotes Mauldin who quotes Rosenberg. And then have someone quote me.
Rosenberg, incidentally, mentions an interesting set of statistics that never gets much attention, the BLS Household Survey.
As an aside, the Bureau of Labor Statistics also publishes a number from the Household survey that is comparable to the nonfarm survey (dubbed the population and payroll-adjusted Household number), and on this basis, employment sank — brace yourself — by over 1 million, which is unprecedented.
Note: the Household survey is different from and smaller than the non-farm survey, but that doesn’t make it irrelevant. And the difference between the 216,000 jobs lost according to the non-farm survey versus the almost 5 times as many in this one looks suspicious.
I wanted to put in the income tax graphs because they are the best approximation we seem to have of what happens at all levels of government when it comes to their revenues: they are plunging. Moreover, while federal income tax is allegedly down about 11%, we've seen earlier in the year that business taxes are off by as much as 50%. The New Fiscal Year Brings No Relief From Unprecedented State Budget Problems report shines some light on the extent of revenue losses at state level.
- At least 48 states have addressed or still face shortfalls in their budgets for fiscal year 2010 totaling $168 billion or 24% of state budgets.
- An unusual number of these states are still struggling to balance their 2010 budgets two months after the start of the fiscal year. Three states [..] have not yet adopted budgets for 2010. In addition, new shortfalls have opened up in at least 15 of the states that have adopted budgets [..] . These additional gaps — some of which have already been addressed — totaled $28 billion.
- At least 36 states have looked ahead and anticipate deficits for fiscal year 2011. These shortfalls total $74 billion — 15 percent of budgets — for the 30 states that have estimated the size of these gaps by comparing expected spending with estimated revenues.
- [..] state budget gaps will continue to be significantly larger than in the last recession. All but a handful of states have had to face or are still dealing with shortfalls in fiscal year 2010 that total some $168 billion. If, as is widely expected, the economy does not begin to significantly recover until some time in calendar year 2010 and unemployment remains high through 2010, state shortfalls are likely to be even larger in fiscal year 2011 (which begins in July 2010 in most states). The deficits over the next two fiscal years — 2010 and 2011 — are likely to be more than $350 billion..
Now, first of all: California is the big stinking elephant in the room. Its predicaments add greatly to the absolute numbers, since it’s so large, and -at least for now- likely also to the percentages. That said, it is a state, and should remain part of the overall story. Which, by the way, puts total state budget spending at $700 billion. Which will go down significantly before the fiscal year is over. That's after all where the pain is.
The average shortfall for the 2010 fiscal year (July 1 2009-June 30 2010) is 24,3% of the total budget. The biggest gaps: California: 49.3% , Arizona: 41.1%, Nevada: 37.8%, Illinois: 37.7% , New York: 36.1%, Alaska: 30.0%.
And that’s not all. Two months after fiscal year 2010 began, there are already $28 billion in additional "losses". Potentially, that could add another $168 billion (6x$28 billion) to the shortfalls, which would double the gap to $336 billion, or 48% of total budgets. Again, California plays an outsize role here, it’s for example responsible for about two-thirds of the additional gap, which also has already been "addressed", but before that starts to make you feel better, don't forget that it may continue to "surprise" on the downside. California has some of the highest foreclosure and unemployment numbers around, which will impact losses significantly.
But that's not all either. For fiscal year 2011, expectations are even worse than for 2010. Note: the report uses the phrase "at least" a lot, because a number of states don't have numbers available. The preliminary estimated budget gap for FY 2011 is $182 billion, based on "expected spending and estimated revenues".
Of course, if we can agree that FY2011 is likely to be worse than FY 2010, we need to take into account the already "discovered" and additional potential gaps in the 2010 numbers. When you look at it that way, the estimated $350 billion, 25%, gap over two years ($168 billion + $182 billion) seems to be on the very conservative side. There is no way incumbent politicians as a group have erred on the side of caution. The vast majority will have erred on the side of positivism, for reasons varying from wanting re-election to not understanding the data.
This depicts a huge problem in the making. rainy day funds are rapidly being depleted, while the worst is yet to come. Something will have to give, since states are obliged to balance their books and can't borrow to do that. So what happens? Politicians and high-end civil servants cutting their own salaries? Not very likely. Here's the report again:
- As the 2009 fiscal year ended and states planned for 2010, budget difficulties have led some 41 states to reduce services to their residents, including some of their most vulnerable families and individuals.
- For example, at least 27 states have implemented cuts that will restrict low-income children’s or families’ eligibility for health insurance or reduce their access to health care services. Programs for the elderly and disabled are also being cut. At least 24 states and the District of Columbia are cutting medical, rehabilitative, home care, or other services needed by low-income people who are elderly or have disabilities, or significantly increasing the cost of these services.
- At least 25 states are cutting or proposing to cut K-12 and early education; several of them are also reducing access to child care and early education, and at least 34 states have implemented cuts to public colleges and universities. In addition, at least 42 states and the District of Columbia have made cuts reducing the size or work time of state government employees.
To wit, this little tidbit from the state of Washington which is but a first warning sign (good times to be a lawyer):
Judge orders state nursing, rehab cuts restored
Nearly 1,000 of Washington's most disabled citizens are cheering and state budget cutters are headed back to the drawing board after an unexpected court ruling Friday. A judge ruled the state improperly cut publicly-funded nursing and rehabilitation services for many of the state's most vulnerable citizens.
My take when overseeing all these data is that you can take the picture we have so far and multiply it by a factor of magnitude. That's the future of US states and their level of services provided. They’ll try to open casino's, raise sales taxes, property taxes, squeeze the old and the crippled, anything they feel they can get away with while holding on to their posts. They’ll also lean ever heavier on counties and municipalities, the very entities that must already be bleeding profusely as we speak, but from which we have no comprehensive data as of yet.
Is there any chance the states (and the counties and towns) can count on Washington to help? Well, how's the federal government doing these days amidst all this? Here's former GAO head David Walker with some perspective:
Warning: The Deficits Are Coming!
"Our $56 trillion in unfunded obligations amount to $483,000 per household. That's 10 times the median household income—so it's as if everyone had a second or third mortgage on a house equal to 10 times their income but no house they can lay claim to." As for this year's likely deficit of $1.8 trillion, Mr. Walker suggests its size be conveyed thusly: "A deficit that large is $3.4 million a minute, $200 million an hour, $5 billion a day," he says. That does indeed put things into perspective.
That's right. Every American on average pays $6000 towards the federal deficit this year. Think it's a good idea to dig the hole a bit deeper in order to support the states? As an aside, can you imagine having to borrow $200 million an hour?
Washington has predicted grandiose increases in GDP of around 4%, starting this year. If those increases either don't materialize or are short-lived, everything I've listed above will make a sharp turn for the worse. And there's absolutely nothing in sight that supports that sort of GDP growth predictions other than more stimulus packages provided by that same federal government.
Down the line the change we can (or once could) believe in turns into "the more we spend, the richer we are". I for one will have to pass on that one. Meanwhile, I think it borders on criminal behavior to cut budgets for the defenseless amongst us, while those doing the cutting sit pretty and rake in multi-million dollar donations for their next campaigns. Then again, it would be naive not to see by now that that's how it works. In times of plenty, we all ignore the obvious cracks in the system, and when times get leaner and the cracks widen, we start falling through them.
Ilargi: Click the title to go to the original and see tables with info specific to your favorite states.
New Fiscal Year Brings No Relief From Unprecedented State Budget Problems
The unprecedented state fiscal problems brought on by the worst decline in tax receipts in decades show no signs of letting up. On July 1 — the start of the fiscal year in most states — an unusually high number of states were still struggling to adopt budgets for fiscal year 2010. Most states have adopted budgets that closed the shortfalls they faced with a combination of federal stimulus dollars, service reductions, revenue increases, and funds from reserves. But these budgets are already falling out of balance as the economy has caused state revenues to decline even more than projected. States will continue to struggle to find the revenue needed to support critical public services for a number of years.
The Center’s most recent survey of state fiscal conditions found many signs of the depth of the state budget crisis.
- At least 48 states have addressed or still face shortfalls in their budgets for fiscal year 2010 totaling $168 billion or 24 percent of state budgets.
- An unusual number of these states are still struggling to balance their 2010 budgets two months after the start of the fiscal year. Three states — Arizona, Michigan, and Pennsylvania — have not yet adopted budgets for 2010. In addition, new shortfalls have opened up in at least 15 of the states that have adopted budgets — California, Colorado, Georgia, Hawaii, Kansas, Kentucky, Maryland, New Mexico, New York, Rhode Island, Utah, Vermont, Virginia, Washington, and Wyoming — plus the District of Columbia . These additional gaps — some of which have already been addressed — totaled $28 billion.
- The states’ fiscal problems will continue into the next fiscal year and likely beyond. At least 36 states have looked ahead and anticipate deficits for fiscal year 2011. These shortfalls total $74 billion — 15 percent of budgets — for the 30 states that have estimated the size of these gaps by comparing expected spending with estimated revenues, and are likely to grow as more states prepare projections and revenues continue to deteriorate.
- Combined budget gaps for the next two fiscal years — those already mostly closed for 2010 and those projected for 2011 — are estimated to total at least $350 billion.
Figure 2’s budget shortfall figures for fiscal years 2009 and 2010 show the national recession’s impact on state budgets. These figures are the total size of the shortfall identified by each state listed. In many cases all or part of this shortfall has already been closed through a combination of spending cuts, withdrawals from reserves, revenue increases, and use of federal stimulus dollars.
Figure 2 also compares the size and duration of the shortfalls that occurred in the recession of the first part of this decade to shortfalls this time. The current recession is more severe — deeper and longer — than the last one, and state fiscal problems have proven to be worse and are likely to remain so. Unemployment, which peaked after the last recession at 6.3 percent, has already hit 9.4 percent, and many economists expect it to rise higher. This would further reduce state income tax receipts and increase demand for Medicaid and other essential services that states provide. With consumers’ reduced access to home equity loans and other sources of credit, sales tax receipts have fallen more steeply than in the last recession. These factors suggest that state budget gaps will continue to be significantly larger than in the last recession. All but a handful of states have had to face or are still dealing with shortfalls in fiscal year 2010 that total some $168 billion. If, as is widely expected, the economy does not begin to significantly recover until the some time in calendar year 2010 and unemployment remains high through 2010, state shortfalls are likely to be even larger in fiscal year 2011 (which begins in July 2010 in most states). The deficits over the next two fiscal years — 2010 and 2011 — are likely to be more than $350 billion. 
Several factors could make it particularly difficult for states to recover from the current fiscal situation. Housing markets might be slow to fully recover; their decline already has depressed consumption and sales tax revenue as people refrain from buying furniture, appliances, construction materials, and the like. This also would depress property tax revenues, increasing the likelihood that local governments will look to states to help address the squeeze on local and education budgets. And as the employment situation continues to deteriorate, income tax revenues will weaken further and there will be further downward pressure on sales tax revenues as consumers are reluctant or unable to spend.
Unlike the federal government, the vast majority of states are governed under rules that prohibit them from running a deficit or borrowing to cover their operating expenses. As a result, states have three primary actions they can take during a fiscal crisis: draw down available reserves, cut spending, and raise taxes. States already have begun drawing down reserves; the remaining reserves are not sufficient to allow states to weather the remainder of the recession. The other alternatives — spending cuts and tax increases — can further slow a state’s economy during a downturn, which produces a cumulative negative impact on national recovery as well.
Some states have not been affected by the economic downturn, but the number is dwindling. Mineral-rich states — such as New Mexico, Alaska, and Montana — saw revenue growth as a result of high oil prices. However, the recent decline in oil prices has begun to affect revenues in some of these states. The economies of a handful of other states have so far been less affected by the national economic problems.
In states facing budget gaps, the consequences are severe in many cases — for residents as well as the economy. As the 2009 fiscal year ended and states planned for 2010, budget difficulties have led some 41 states to reduce services to their residents, including some of their most vulnerable families and individuals.
For example, at least 27 states have implemented cuts that will restrict low-income children’s or families’ eligibility for health insurance or reduce their access to health care services. Programs for the elderly and disabled are also being cut. At least 24 states and the District of Columbia are cutting medical, rehabilitative, home care, or other services needed by low-income people who are elderly or have disabilities, or significantly increasing the cost of these services.
At least 25 states are cutting or proposing to cut K-12 and early education; several of them are also reducing access to child care and early education, and at least 34 states have implemented cuts to public colleges and universities.
In addition, at least 42 states and the District of Columbia have made cuts reducing the size or work time of state government employees. Such cuts not only often result in reduced access to services residents need, but also add to states’ woes because of the impact on the economy from less consumer activity.
If revenue declines persist as expected in many states, additional spending and service cuts are likely. Budget cuts often are more severe later in a state fiscal crisis, after largely depleted reserves are no longer an option for closing deficits.
Expenditure cuts and tax increases are problematic policies during an economic downturn because they reduce overall demand and can make the downturn deeper. When states cut spending, they lay off employees, cancel contracts with vendors, eliminate or lower payments to businesses and nonprofit organizations that provide direct services, and cut benefit payments to individuals. In all of these circumstances, the companies and organizations that would have received government payments have less money to spend on salaries and supplies, and individuals who would have received salaries or benefits have less money for consumption. This directly removes demand from the economy. Tax increases also remove demand from the economy by reducing the amount of money people have to spend — though to the extent these increases are on upper-income residents that effect is minimized because much of the money comes from savings and so does not diminish economic activity.
The federal government — which can run deficits — can provide assistance to states and localities to avert these “pro-cyclical” actions.
States Have Restrained Spending and Accumulated Rainy Day Funds
The current situation has been made more difficult because many states never fully recovered from the fiscal crisis of the early part of the decade. This heightens the potential impact on public services of the shortfalls states now are projecting.
State spending fell sharply relative to the economy during the 2001 recession, and for all states combined it still remains below the fiscal year 2001 level. In 18 states, general fund spending for fiscal year 2008 — six years into the economic recovery — remained below pre-recession levels as a share of the gross domestic product.
In a number of states the reductions made during the downturn in education, higher education, health coverage, and child care remain in effect. These important public services were suffering even as states turned to budget cuts to close the new budget gaps. Spending as a share of the economy declined in fiscal year 2008 and is projected to decline further in 2009 and again in 2010.
One way states can avoid making deep reductions in services during a recession is to build up rainy day funds and other reserves when the economy is growing. At the end of fiscal year 2006, state reserves — general fund balances and rainy day funds — totaled 11.5 percent of annual state spending. Reserves can be particularly important to help states adjust in the early months of a fiscal crisis, but generally are not sufficient to avert the need for substantial budget cuts or tax increases. In this recession, states have already drawn down much of their available reserves; the available reserves in states with deficits are likely to be depleted in the near future.Federal Assistance Crucial
Federal assistance can lessen the extent to which states need to take pro-cyclical actions that can further harm the economy. The American Recovery and Reinvestment Act recognizes this fact and includes substantial assistance for states. The amount in ARRA to help states maintain current activities is about $135 billion to $140 billion — or less than half of projected state shortfalls. Most of this money is in the form of increased Medicaid funding and a “Fiscal Stabilization Fund.” This money has reduced to a degree the depth of state spending cuts and moderated state tax and fee increases. There are also other streams of funding in the economic recovery act flowing through states to local governments or individuals, but this will not address state budget shortfalls.
Warning: The Deficits Are Coming!
David Walker sounds like a modern-day Paul Revere as he warns about the country's perilous future. "We suffer from a fiscal cancer," he tells a meeting of the National Taxpayers Union, the nation's oldest anti-tax lobby. "Our off balance sheet obligations associated with Social Security and Medicare put us in a $56 trillion financial hole—and that's before the recession was officially declared last year. America now owes more than Americans are worth—and the gap is growing!"
His audience sits in rapt attention. A few years ago these antitax activists would have been polite but a tad restless listening to the former head of the Government Accountability Office, the nation's auditor-in-chief. Higher taxes is what hikes their blood pressure the most, but the profligate spending of the Bush and Obama administrations has put them in a mood to listen to this green-eyeshade Cassandra. "He's so unlike most politicians," says Sharron Angle, a former state legislator from Nevada, "his message is clear, detailed and with no varnish."
Mr. Walker, a 57-year-old accountant, didn't set out to be a fiscal truth-teller. He rose to be a partner and global managing director of Arthur Anderson, before being named assistant secretary of labor for pensions and benefits during the Reagan administration. Under the first President Bush, he served as a trustee for Social Security and Medicare, an experience that convinced him both programs are looming train wrecks that could bankrupt the country. In 1998 he was appointed by President Bill Clinton to head the GAO, where he spent the next decade issuing reports trying to stem waste, fraud and abuse in government.
Despite many successes, he was able to make only limited progress in reforming Washington's tangled bookkeeping. When he arrived he was told the Pentagon was nearly a decade away from having a clean audit, or clear evidence that its financial statements were accurate. When he left in 2008, he was told the Pentagon was still a decade away from that goal. "If the federal government was a private corporation, its stock would plummet and shareholders would bring in new management and directors," he said as he retired from the GAO.
Although he found the work fulfilling, Mr. Walker said he decided to leave last year with a third of his 15-year term left because "there are practical limits on what one can—and cannot—do in that job." He became president and CEO of the Peter G. Peterson Foundation, a group seeking to educate the public and policy makers on the need for fiscal prudence. Although it accepts private donations, its own future is secure given that Mr. Peterson, a former head of the Blackstone private equity firm and secretary of commerce under Richard Nixon, has endowed it with a $1 billion gift.
We met to hash over current events in his tastefully appointed office just off of New York's Fifth Avenue. Mr. Walker, a lean man with an unflappable demeanor, welcomed me with the observation that he's never been in more demand as a speaker "but it's only because everyone is so worried for our future." His group calls itself strictly nonpartisan and nonideological, and that seems to limit how tough and specific it can be. Last year, it released a documentary "I.O.U.S.A.," that followed Mr. Walker as he toured the country on his fiscal "wake up" tour. The solutions the film proposes for the debt crisis are either glib or gray: The country should save more, reduce oil consumption, hold politicians accountable and get more value from health-care spending.
But in its diagnosis of the problem the film scores a bull's-eye. Among the fiscal hawks featured in the film is Rep. Ron Paul, who memorably tells Alan Greenspan that if doctors had the same success rate in meeting his goals as the Fed has had, patients would be dead all over America. Mr. Walker's own speeches are vivid and clear. "We have four deficits: a budget deficit, a savings deficit, a value-of-the-dollar deficit and a leadership deficit," he tells one group. "We are treating the symptoms of those deficits, but not the disease."
Mr. Walker identifies the disease as having a basic cause: "Washington is totally out of touch and out of control," he sighs. "There is political courage there, but there is far more political careerism and people dodging real solutions." He identifies entrenched incumbency as a real obstacle to change. "Members of Congress ensure they have gerrymandered seats where they pick the voters rather than the voters picking them and then they pass out money to special interests who then make sure they have so much money that no one can easily challenge them," he laments.
He believes gerrymandering should be curbed and term limits imposed if for no other reason than to inject some new blood into the system. On campaign finance, he supports a narrow constitutional amendment that would bar congressional candidates from accepting contributions from people who can't vote for them: "If people can't vote in a district not their own, should we allow them to spend unlimited money on behalf of someone across the country?"
Recognizing those reforms aren't "imminent," Mr. Walker wants Congress to create a "fiscal future commission" that would hold hearings all over America to move towards a consensus on reform. It would then present Congress with a "grand bargain" on entitlement and budget-control reforms. Its recommendations would be guaranteed a vote in Congress and be subject to only limited amendments. I note that critics have called such a commission an end-run around the normal legislative process. He demurred, saying that Congress would still have to approve any recommendations in an up-or-down vote—much like the successful base-closing commission created by GOP Rep. Dick Armey in the 1980s.
What kind of reforms would Mr. Walker hope the commission would endorse? He suggests giving presidents the power to make line-item cuts in budgets that would then require a majority vote in Congress to override. He would also want private-sector accounting standards extended to pensions, health programs and environmental costs. "Social Security reform is a layup, much easier than Medicare," he told me. He believes gradual increases in the retirement age, a modest change in cost-of-living payments and raising the cap on income subject to payroll taxes would solve its long-term problems.
Medicare is a much bigger challenge, exacerbated by the addition of a drug entitlement component in 2003, pushed through a Republican Congress by the Bush administration. "The true costs of that were hidden from both Congress and the people," Mr. Walker says sternly. "The real liability is some $8 trillion." That brings us to the issue of taxes. Wouldn't any "grand bargain" involve significant tax increases that would only hurt the ability of the economy to grow? "Taxes are going up, for reasons of math, demographics and the fact that elements of the population that want more government are more politically active," he insists. "The key will be to have tax reform that simplifies the system and keeps marginal rates as low as possible. The longer people resist addressing both sides of the fiscal equation the deeper the hole will get."
I steer towards the fiscal direction of the Obama administration. He says his stimulus bill was sold as something it wasn't: "A number of people had agendas other than stimulus, and they shaped the package." As for health care, Mr. Walker says he had hopes for comprehensive health-care reform earlier this year and met with most of the major players to fashion a compromise. "President Obama got the sequence wrong by advocating expanding coverage before we've proven our ability to control costs," he says.
"If we don't get our fiscal house in order, but create new obligations we'll have a Thelma and Louise moment where we go over the cliff." Mr. Walker's preferred solution is a plan that combines universal coverage for all Americans with an overall limit on the federal government's annual health expenditures. His description reminds me of the unicorn—a marvelous creature we all wish existed but is not likely to ever be seen on this earth.
As I prepare to go, Mr. Walker returns to the theme of economic education. Poor schools often produce young people with few tools to help them realize the extent of the fiscal trap their generation is going to fall into. One way the Peterson Foundation wants to change that is to bring big numbers down to earth so people can comprehend them. "Our $56 trillion in unfunded obligations amount to $483,000 per household. That's 10 times the median household income—so it's as if everyone had a second or third mortgage on a house equal to 10 times their income but no house they can lay claim to." As for this year's likely deficit of $1.8 trillion, Mr. Walker suggests its size be conveyed thusly: "A deficit that large is $3.4 million a minute, $200 million an hour, $5 billion a day," he says. That does indeed put things into perspective.
Despite an occasional detour into support for government intervention, Mr. Walker remains the Jeffersonian he grew up as in his native Virginia. "I view the Constitution with deep respect," he told me. "My ancestors and those of my wife fought and died in the Revolution, and I care a lot about returning us to the principles of the Founding Fathers." He notes that today the role of the federal government has grown such that last year less than 40% of it related to the key roles the Founders envisioned for it: defense, foreign policy, the courts and other basic functions. "What happened to the Founders' intent that all roles not expressly reserved to the federal government belong to the states, and ultimately the people?" he asks. "I'm pleased the recent town halls show people are waking up and realizing it's time to pay attention to first principles."
With that we parted, as he had to get back to work. Today's Paul Revere is hard at work on a book due out in January from Random House that will be called, "Come Back America."
Ilargi: Iknow, it's at least a bit weird to post an article by Henry Blodget which quotes John Mauldin who quotes Dave Rosenberg. Thing is, this is the version that works best for me.
Economy Will Be Back In Recession By Early Next Year
We would like to believe that the economy is going to go roaring right back to steady 3%-4% growth. But we still haven't seen compelling facts to support that view.
The bullish argument is that this is simply the way economies recover. And the stimulus-fueled rebound of Q2 and Q3 has certainly been v-shaped (see chart below--which will continue up and to the right in Q3).
But this argument does not explain how consumer spending is going to quickly rev back up to sustainable 3%-4% growth in the face of massive debts, 10% unemployment, huge government deficits, tight credit, and a weak housing market--or that, if consumer spending does not recover, where else the spending is going to come from.
The bearish case, meanwhile, is that this recession is different--a deleveraging recession--and that full recovery will take years. The key element of this latter view is ongoing weakness in consumer spending. To wit:
- Consumers still account for 70% of the spending in the economy
- Consumer spending growth will be constrained by the facts that
- consumers still have debt coming out of their ears
- unemployment is 10% and rising
- Business spending (the other 30% of the economy) depends to some extent on consumer spending
With that as the backdrop, we just don't see how we quickly return to the Old Normal--with a couple of 5%-7% growth years first to make up for lost time.
We're all ears, though. If you have any good theories, please send them along.
In the meantime, here's the latest thinking from John Mauldin, who is (almost) as bearish as ever. Specifically, he's predicting that the economy will be back in recession by early next year.
Unemployment Was NOT a Green Shoot
But quickly, let's look at today's unemployment numbers. This was not the way one would want to celebrate Labor Day. Unemployment rose to 9.7%. Some take comfort in that unemployment in the Establishment Survey (where they call existing business and poll them) was only down by 216,000, which admittedly is better than 600,000 but is still a very bad number. Rising unemployment is not the stuff that inflation is typically made of. And there are reasons to think the picture may be worse than that. Here are a few thoughts from David Rosenberg:
"What was really key were the details of the Household Survey, which provide a rather alarming picture of what is happening in the labor market.
"First, employment in this survey showed a plunge of 392,000, but that number was flattered by a surge in self-employment (whether these newly minted consultants were making any money is another story) as wage & salary workers (the ones that work at companies, big and small) plunged 637,000 — the largest decline since March (when the stock market was testing its lows for the cycle). As an aside, the Bureau of Labor Statistics also publishes a number from the Household survey that is comparable to the nonfarm survey (dubbed the population and payroll-adjusted Household number), and on this basis, employment sank — brace yourself — by over 1 million, which is unprecedented. We shall see if the nattering nabobs of positivity discuss that particularly statistic in their post-payroll assessments; we are not exactly holding our breath."
The ISM numbers came out this week and, while manufacturing is up, the service industry (which is far larger) is still contracting, and the employment elements in the surveys show employers are still planning to cut jobs. Think about almost 11% unemployment next summer in the middle of the political season. Watch the competition among politicians to demonstrate they care and "get it." And watch as they spend your money to show how much they care.
And from the above mentioned Liscio Report: "As we outlined back in May, financial crises hammer employment, resulting in average losses of 6.3% followed by a long flat line. We hate to point it out, but we're currently down 4.8% from the December 2007 onset, and if US job losses in this recession stay in line with the major financial recessions in "advanced" countries studied by the IMF, we stand to lose another 1.8 million jobs. Some of those will likely be taken out in upcoming benchmarks, stimulus money has some clout, and no one has a reliable crystal ball, but we need to remember where we are in a painful cycle if we see some hopeful flickers."
That would take us to well over 11% unemployment.
Interesting statistic. Want to know where wages are rising? Think federal government workers. The gap between civilian and government workers was less than $13,000 nine years ago, but now is almost $30,000. Inflation has been 24%, but government wages are up 55%. According to a recent release from Rasmussen Reports, a government job remains "the top employment choice in today's economic environment." (chart from Clusterstock)
States, counties, and cities are having to make deep cuts, in both jobs and programs. Today's Wall Street Journal talks about the cuts in state after state. States cannot print money like the US can, so at some point they have to either raise taxes or cut spending to balance their budgets. Raising taxes just makes it less profitable for businesses to remain in your state. There is a very high correlation with high state taxes and unemployment.
The following chart shows how rapidly income taxes are falling. Sales tax receipts are down. At some point voters are going to demand that their federal government show some of the same restraint that households, cities, and counties are being forced into. My bet is that next year raises for government workers, even those in unions, will come under attack. They won't be cut, but watch as political backlash builds.
Without federal stimulus, the GDP of the US would have been over minus 6% in the second quarter, not the minus 1% it was. The third quarter would be flat to down and not the plus 3% it is likely to be. Housing and autos will turn down as the stimulus on those markets goes away.
I think it is very possible we will see a negative GDP by the first quarter of next year. Unemployment will still be rising. Deflation will be more of a problem, because the housing component (the largest portion of the consumer-inflation index), based roughly on rentals, is clearly under pressure. While we don't have enough space this week to go into detail, savings are up and consumer spending is down. Without the stimulus, things would be much worse.
Here's the kicker. Expect to see a big push for another large stimulus package next spring (and maybe sooner), as the effects of the current one wear off. The government wants to bring back demand by getting consumers to spend again. And you can count on unemployment benefits being extended. A tax holiday on Social Security taxes below a certain income? In the short run they can do it, but at a long-run cost.
It is going to be hard for a Democratic administration to not push for another large stimulus. That is what Krugman and his fellow travelers will be pushing. Classic Keynesian thinking wants both for the government to run large deficits and for the central bank to print more money. Remember, last year I said that the Fed would print a lot more money than they are talking about in the current plans. They are going to have the cover to do so, because deflation is going to be seen as the problem.
Next week, we will look at money supply and the velocity of money, savings, consumer demand, and more as we further explore the complex molecule that is deflation.
But one last thought, as I have had a lot of questions on gold recently. "Isn't gold telling us that inflation is coming back?" The answer is no. Since the early '80s the correlation between gold and inflation has dropped to zero. Gold has had very little to say in the last 30 years about inflation.
But what it may be saying is that paper currencies are a problem. Gold is going up not only in dollar terms, but in euros, pounds, yen, and more. My view is that gold should be seen as a neutral currency. The dollar is the worst currency in the world, except for all the others. Is it possible the Fed will not respond and print more money next year? Sure. And the dollar could rise as deflation kicks in. The only time we saw the purchasing power of the dollar rise in a sustained manner was during deflation, in the last century.
The race is not always to the swiftest or the fight to the strongest, but that's the way to bet. And right now, my bet is the Fed will print money to fight a double-dip recession and deflation. And gold would be one way to play that bet.
Massachusetts: State jobless pay to end for many
Massachusetts is experiencing its first wave of jobless workers to exhaust unemployment benefits after nearly two years of rising unemployment, state labor officials said. The state this week sent out letters notifying about 2,500 jobless workers that they had or would soon receive their last unemployment checks, having used up state and federal extensions that provided up to 79 weeks, or about 18 months, of benefits. The state expects about 21,000 jobless workers to run out of unemployment benefits by Thanksgiving.
Nationally, about 400,000 jobless workers will exhaust their benefits over the next few months. "They shouldn’t give up hope,’’ said Suzanne Bump, state secretary of labor and workforce development. "They should continue job searches, no matter how discouraging the results have been. They should avail themselves of all the state and nonprofit assistance available.’’ Those who have exhausted jobless benefits could be eligible for welfare, food stamps, and other social assistance programs. In the letter, labor officials provided a list of state and nonprofit agencies that may be able to help. Residents also can call 211, a state hot line staffed by specialists to provide referrals and information about health and human services.
The depletion of unemployment benefits is another measure of the depth of the national recession, widely viewed as the worst since the Great Depression. US employers have cut back employment for 20 consecutive months, slashing payrolls by more than 7 million jobs. Since the recession began in December 2007, the unemployment rate has nearly doubled to 9.7 percent, from 4.9 percent. In Massachusetts, the recession began a little later, but the plunge has been nearly as swift. The jobless rate jumped to 8.8 percent in July, from 4.7 percent in March 2008, when the recession began here. Many economists expect unemployment in the state to exceed the 9.1 percent reached during the recession of the early 1990s.
Massachusetts employers have cut nearly 120,000 jobs, or about 4 percent of employment, since the recession began. In July, the state changed a law to prevent as many as 85,000 jobless residents from losing federally funded extended benefits. Long-term unemployment has become a growing problem across the nation, one that Congress is likely to take up after lawmakers return from summer recess next week. Among the concerns: An emergency federal program that provides up to 33 additional weeks of benefits is set to expire at the end of the year. Bump said Governor Deval Patrick has been working with other governors to press Congress for additional relief. "We haven’t seen this kind of job loss in 60 years,’’ she said.
US families turn to food stamps as wages drop
The number of working Americans turning to free government food stamps has surged as their hours and wages erode, in a stark sign that the recession is inflicting pain on the employed as well as the newly jobless. While the increase in take-up is often attributed to the sharp rise in unemployment – which on Friday hit 9.7 per cent – the Financial Times has learnt that some 40 per cent of the families now on food stamps have "earned income", up from 25 per cent two years ago.
The agriculture department, which runs the programme, attributes this rise to workers having their hours cut back. "I’m sort of stunned, it seems like a dire warning that even the jobs people are retaining in this recession aren’t at the wage level and hours level that they need to provide for their families," said Heidi Shierholz, economist at the Economic Policy Institute. The pace of outright job losses in the US has started to recede, prompting hopes that the labour market could be stabilising. Official figures on Friday showed that non-farm payrolls dropped by a better than expected 216,000 in August, but still marked the 20th consecutive month that the US economy has shed jobs.
Less attention has been paid to those still in the workforce, whose incomes are also being squeezed. The average working week is now about 33 hours, the lowest on record, while the number forced to work part-time because they cannot find full-time work has risen more than 50 per cent in the past year to a record 8.8m. Wages and benefits have decelerated. The food stamp data suggest that "the labour market problems are more significant than you would expect, given just the unemployment rate", said John Silvia, chief economist at Wells Fargo. "For me it suggests the consumer is not going to rebound or contribute to economic growth for the next year, as the consumer would in a traditional economic recovery."
Consumer spending has traditionally been the engine of the US economy, making up about two thirds of GDP. Economists fear that people may be unwilling to resume that role. Kevin Concannon, undersecretary for food, nutrition and consumer services at the agriculture department, called the increased enrolment of working families "very significant". Food stamps are distributed once a month on electronic cards that can be spent at many grocery stores. The $787bn stimulus bill added about $80 (€55, £50) to a family’s monthly allowance, which now stands at an average $290.
4 stimulus breaks due to run out at year end
Time could be running out for some key tax and spending provisions in the federal stimulus act that are set to expire by Dec. 31. These include beefed-up unemployment benefits, the sales tax deduction for new-vehicle purchases, a federal subsidy for Cobra health-insurance premiums and the $8,000 first-time home-buyer credit. Although these provisions were meant to be temporary, Congress has a hard time saying goodbye to any goodies and an even harder time paying for them. When they come back to work this week, lawmakers will have to decide whether to extend a raft of other tax breaks that were supposed to die years ago but keep getting renewed one year at a time.
Congress could renew the expiring stimulus provisions, but not without "real macroeconomic risks," says Maya MacGuineas, president of the Committee for a Responsible Federal Budget. "The stimulus was crafted to be a temporary jolt to get the economy going again. The bargain at the time was, you don't pay for stimulus. But if you want to extend those policies, you have to find a way to pay for them, particularly because of the massive challenges we already face."
Here's a look at some expiring provisions and their prospects for renewal:
- Cobra subsidy: Workers who are terminated between Sept. 1, 2008, and Dec. 31, 2009, and are eligible to stay in their group health plan at their own expense under the law known as Cobra can get the government to pay 65 percent of their premium for up to nine months, as long as they are not eligible for Medicare or any other group health plan.
People who started getting the subsidy when it became available March 1 run out after November. People who are still getting the subsidy at year end can continue until it's used up. But people who get laid off after Dec. 31 won't get any subsidy. There are no bills to extend the subsidy, but it's likely to come up. The subsidy "was supposed to be a bridge to get us to health care reform," MacGuineas says. "If health care doesn't get fixed, maybe they will keep this Cobra subsidy in place."
- Home-buyer credit: People who buy a home to live in before Dec. 1 and have not owned a home in the past three years can get a tax credit up to $8,000. The credit phases out for higher-income people. To qualify, you must close by Nov. 30.
S1230, sponsored by Johnny Isakson, R-Ga., would expand the credit to $15,000, remove the income restriction, open it up to all home buyers and extend it for one year after enactment. "Given the fact that home pries are still declining and there's a lot of inventory on the market, the credit is something that may well be extended," though not necessarily expanded as the bill envisions, says Bob Scharin, senior tax analyst at the tax and accounting division of Thomson Reuters.
Joshua Gordon, policy director with the Concord Coalition, says extending it makes no sense. "The whole point is to stimulate home buying. You don't do that if the credit is thought to be permanent - no one has an incentive to buy now rather than wait." He adds that the credit might be having "a perverse incentive. People are trying to buy homes before it expires, which is causing home prices to go up, which is causing some buyers to pay more than the $8,000 credit is worth."
- Unemployment: The stimulus act increased the weekly unemployment benefit by $25 per week, allowed people to deduct up to $2,400 in benefits on their federal tax return and extended the federal government's extended benefits program, which provides additional compensation to people who have used up their regular state benefits.
In California, a person who exhausted 26 weeks of state benefits could get up to 20 more weeks under the first federal extension, then up to 13 weeks under a second extension and up to 20 weeks more under a third extension. The first and second extensions were supposed to expire in the spring but the stimulus extended them until Dec. 31. The stimulus also provided 100 percent federal funding for the third extension.
All these federal benefits sunset after Dec. 31. A person who was already receiving extended benefits on Jan. 1 could finish that round of benefits, but not start the next extension. A person who was still receiving their regular state benefits on Jan. 1 would get no extended benefits. HR3404, sponsored by Rep. Jim McDermott, D-Wash., would extend all of the expiring provisions through next year. It also would create a fourth extension of up to 13 weeks for people in high-unemployment states.
To help people who will receive their last check in the next few months, McDermott plans to put the fourth extension into a separate bill and focus on passing that quickly. The rest will go into another bill, says Mike DeCesare, McDermott's press secretary. Sen. Jack Reed, D-R.I., has introduced a similar bill, S1647.
- New-car deduction: If you buy a new vehicle between Feb. 17 and Dec. 31 of this year, you can deduct the sales tax on up to $49,500 of the purchase price on your federal tax return. The deduction phases out for higher-income taxpayers. This incentive got overshadowed by Cash for Clunkers.
"I haven't heard a peep" about extending the deduction, says Roberton Williams, senior fellow with the Tax Policy Center. "The fact that we are seeing some economic revival means there is less pressure to do more for a specific industry." But Scharin says he wouldn't count an extension out. The car industry has political clout and the deduction has broad appeal because it's available to people whether they itemize their deductions or not.
States Cut Back and Layoffs Hit Even Recipients of Stimulus Aid
It was just five months ago that Vice President Joseph R. Biden Jr. made the New Flyer bus factory here a symbol of the stimulus. With several cabinet secretaries in tow, he held a town-hall-style meeting at the factory, where he praised the company as "an example of the future" and said that it stood to get more orders for its hybrid electric buses thanks to the $8.4 billion that the stimulus law devotes to mass transit.
But last month, the company that administration officials had pictured as a stimulus success story began laying off 320 people, or 13 percent of its work force, having discovered how cutbacks at the state level can dampen the boost provided by the federal stimulus money. The Chicago Transit Authority did use some of its stimulus money to buy 58 new hybrid buses from New Flyer. But Chicago had to shelve plans to order another 140 buses from them after the state money that it had hoped to use to pay for them failed to materialize. The delayed order scrambled New Flyer’s production schedule for the rest of the year, and led to the layoffs.
One of those laid off was David Wahl, 52, who had worked there for a decade and who sat behind the vice president at the town-hall-style meeting, soaking up the optimism of the moment. "With mass transit being pushed so hard," Mr. Wahl recalled, "I figured I’d be able to work until I was 75." The layoffs at New Flyer are a vivid illustration of the way that some of the economic impact of the $787 billion federal stimulus law is being diluted by the actions state and local governments are taking to weather the recession.
While the stimulus law cut federal taxes to inject money into the economy quickly, at least 30 states have raised taxes since January, according to the Center on Budget and Policy Priorities, a liberal fiscal policy group. The stimulus will spend $27.5 billion in federal money on highway projects, but at least 19 states are planning to cut their highway spending this year, according to the American Road & Transportation Builders Association, a trade group. And as the stimulus devotes $8.4 billion to mass transit, transit systems across the nation have been forced to cut service, raise fares and delay capital spending.
Dean Baker, an economist who was an author of a paper called "The State and Local Drag on the Stimulus," said that while the stimulus had undoubtedly helped states, the cutbacks and tax increases at the state and local level threaten to offset much of its economic impact. "The economy doesn’t care whether the dollars are coming from the federal or the state and local level," said Mr. Baker, a co-director of the Center for Economic and Policy Research.
Mr. Biden did not respond directly to news of the layoffs at New Flyer, but another administration official said the stimulus money was expected to help transit agencies buy almost 8,000 new buses, which would help New Flyer and its competitors. Sasha Johnson, a spokeswoman for the Department of Transportation, said stimulus dollars had helped bus companies survive the economic downtown, and would have an increasing effect through the year. "Without the boost provided by Recovery Act orders, bus companies like New Flyer would be even harder hit than they have been," Ms. Johnson said.
In St. Cloud, though, all that red ink from the states dimmed the hopes for more federally financed green jobs, for now. Chicago transit officials — who noted recently that their older buses had enough miles on them to have gone to the moon and back — estimated that they needed $7 billion for capital improvements. But the State of Illinois, facing budget pressure, agreed to spend only $2.7 billion, and not all of that will go to Chicago. The city’s hopes for another 140 buses from here were put off.
New Flyer Industries, which is based in Winnipeg, Manitoba, said over the summer that it still had a large backlog of bus orders, including some from California, Milwaukee, Philadelphia and Rochester, that would use stimulus money. But because its buses are engineered to order for each customer, the company said in a statement, it cannot easily switch its production schedule to fill the gaps left by the delayed order. So the company plans to cut 320 jobs, to reduce its production schedule to 36 units a week from 50, and to close its plants during the last two weeks of the year. Glenn Asham, New Flyer’s chief financial officer, declined to comment further.
Even before New Flyer announced its layoffs, St. Cloud’s mayor, David Kleis, was critical of the stimulus law. He said the two small road projects that were approved by the state were low on the city’s list of priorities, while the city’s top priority — widening a busy, accident-prone intersection in a commercial area — did not make the grade. Neither did his applications for money to pay for more police officers, or for the city’s wastewater treatment plant. "The expectations were just very high here after that town hall meeting," Mr. Kleis said.
Mr. Wahl said the loss of his job was still sinking in. He joined New Flyer soon after it opened the St. Cloud plant in 1999 — he was the 118th employee, he said — and worked on everything from power steering to putting on side panels to installing engines. When the work force unionized, he became president of the local. Last November, he moved to a nonunion job working with transit systems as they prepared to take delivery of the buses. "It was a lot easier on the body," he said. But the switch to a nonunion job also made it easier for him to be in the first round of layoffs, despite his 10 years with the company. "First it’s shock, and then you get angry," Mr. Wahl said. "And then you wonder, What am I going to do?"
So far he has filed for unemployment benefits, and a couple of days after his 52nd birthday, he drove to the Workforce Center in Crow Wing County to see if he might qualify for help getting a driver’s license allowing him to become a long-haul truck driver. The stimulus law may have failed to save Mr. Wahl’s job, but it is helping him out in a way that he hoped he would never need: thanks to a provision in the law that pays 65 percent of the cost of continuing health insurance for the unemployed under the Cobra law, Mr. Wahl’s health insurance bills will now be closer to $400 a month instead of the $1,200 they would have been otherwise.
Dollar Likely to Gain Strength as a Haven for the Nervous
The U.S. dollar seems poised to remain a favorite of investors seeking shelter from economic uncertainty this week, as U.S. employment numbers failed to spark a return to trading on fundamentals. There was little currency news from a meeting of finance ministers and central bank heads from the Group of 20 leading economies to undermine the dollar. In contrast to some recent meetings of G20 officials, there was little open questioning of the dollar's role as the dominant reserve currency.
Investors are getting mixed signals on a global economic recovery, so they are heading into the safe-haven dollar and yen when conditions cloud, but seeking profits in high-yielding currencies, such as the euro, when the outlook brightens. Friday's lukewarm U.S. payroll numbers for August didn't give investors clarity on whether the global economy is headed in the right direction, and left the dollar as part of a risk-aversion strategy. "The market remains a very fragile environment in the sense that we're seeing not only day-to-day reversals, but intraday reversals," said Vassili Serebriakov, currency strategist at Wells Fargo in New York.
The dollar should eventually advance based on signs that the U.S. economy is improving. However, U.S. data to be released this week, which include trade-balance figures, aren't likely to push currencies out of their recent ranges, said analysts. G20 officials -- including U.S. Treasury Secretary Timothy Geithner -- did little to quell doubts about the sustainability of the global economic recovery. At the end of a two-day meeting in London Saturday, they said they "remain cautious about the outlook for growth and jobs," so much so that they would "continue to implement decisively our...expansionary monetary and fiscal policies."
Over recent months, developing economies with large foreign-exchange reserves have expressed dissatisfaction with the dominant role played by the dollar in the international currency and trade system. But there was little comment on that subject during the G20 meeting. "We expect, and the world expects, the dollar to be the principal reserve currency of the global economy for a long period of time," Mr. Geithner said as the meeting ended. Financial markets are closed Monday in the U.S. and Canada for Labor Day, which will tend to keep volumes low early in the week.
China alarmed by US money printing
The US Federal Reserve's policy of printing money to buy Treasury debt threatens to set off a serious decline of the dollar and compel China to redesign its foreign reserve policy, according to a top member of the Communist hierarchy. Cheng Siwei, former vice-chairman of the Standing Committee and now head of China's green energy drive, said Beijing was dismayed by the Fed's recourse to "credit easing" "We hope there will be a change in monetary policy as soon as they have positive growth again," he said at the Ambrosetti Workshop, a policy gathering on Lake Como.
"If they keep printing money to buy bonds it will lead to inflation, and after a year or two the dollar will fall hard. Most of our foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen, and other currencies," he said. China's reserves are more than – $2 trillion, the world's largest. "Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets," he added. The comments suggest that China has become the driving force in the gold market and can be counted on to buy whenever there is a price dip, putting a floor under any correction.
Mr Cheng said the Fed's loose monetary policy was stoking an unstable asset boom in China. "If we raise interest rates, we will be flooded with hot money. We have to wait for them. If they raise, we raise. "Credit in China is too loose. We have a bubble in the housing market and in stocks so we have to be very careful, because this could fall down." Mr Cheng said China had learned from the West that it is a mistake for central banks to target retail price inflation and take their eye off assets. "This is where Greenspan went wrong from 2000 to 2004," he said. "He thought everything was alright because inflation was low, but assets absorbed the liquidity."
Mr Cheng said China had lost 20m jobs as a result of the crisis and advised the West not to over-estimate the role that his country can play in global recovery. China's task is to switch from export dependency to internal consumption, but that requires a "change in the ideology of the Chinese people" to discourage excess saving. "This is very difficult". Mr Cheng said the root cause of global imbalances is spending patterns in US (and UK) and China. "The US spends tomorrow's money today," he said. "We Chinese spend today's money tomorrow. That's why we have this financial crisis." Yet the consequences are not symmetric. "He who goes borrowing, goes sorrowing," said Mr Cheng. It was a quote from US founding father Benjamin Franklin.
How China Cooks Its Books
In February, local Chinese Labor Ministry officials came to "help" with massive layoffs at an electronics factory in Guangdong province, China. The owner of the factory felt nervous having government officials there, but kept his mouth shut. Who was he to complain that the officials were breaking the law by interfering with the firings, he added. They were the law! And they ordered him to offer his workers what seemed like a pretty good deal: Accept the layoff and receive the legal severance package, or "resign" and get an even larger upfront payment.
"I would estimate around 70 percent of workers took the resignation deal. This is happening all over Guangdong," the factory owner said. "I help the Department of Labor, and they'll help me later on down the line." Such open-secret programs, writ large, help China manipulate its unemployment rate, because workers who "resign" don't count toward that number. The government estimates that roughly 20 million migrant factory workers have lost their jobs since the downturn started. But, with "resignations" included, the number is likely closer to 40 million or 50 million, according to estimates made by Yiping Huang, chief Asia economist for Citigroup. That is the same size as Germany's entire work force.
China similarly distorts everything from its GDP to retail sales figures to production activity. This sort of number-padding isn't just unethical, it's also dangerous: The push to develop rosy economic data could actually lead China's economy over the cliff. Western media outlets often portray Chinese book-cooking as part and parcel of a monolithic central government and omnipotent Beijing bureaucrats. But the problem is manifold, a product of centralized government as well as decentralized officials.
Pressure to distort or fudge statistics likely comes from up high -- and it's intense. "China announces its annual objective of GDP growth rate each year. In Chinese culture, the government has to reach the objective; otherwise, they will 'lose face,'" said Gary Liu, deputy director of the China Europe International Business School's Lujiazui International Financial Research Center. "For instance, the government announced that it wanted to ensure a GDP growth rate of 8 percent in 2009, and it has become the priority for government officials to meet that objective."
But local and provincial governmental officials are the ones who actually fiddle with the numbers. They retain considerable autonomy and power, and have a self-interested reason to manipulate economic statistics. When they reach or exceed the central government's economic goals, they get rewarded with better jobs or more money. "The higher [their] GDP [figures], the higher the chance will be for local officials to get promoted," explained Liu.
Such statistical creativity is nothing new in China. In 1958, Chairman Mao proclaimed that China would surpass Britain in steel production within 15 years. He mobilized villages throughout China to establish backyard steel furnaces, where in a futile attempt to reach outrageous production goals, villagers could melt down pots and pans and even burn their own furniture for furnace fuel. This effort produced worthless pig iron and diverted enough labor away from agriculture to be a main driver in the devastating famine of the Great Leap Forward.
Last October, Vice Premier Li Keqiang said in a speech after inspecting China's Statistics Bureau, "China's foundation for statistics is still very weak, and the quality of statistics is to be further improved" -- a brutally harsh assessment coming from a top state official. Indeed, China has predicated its very claim of being the healthiest large economy in the world on faulty statistics. The government insists that even though China's all-important export sector has been devastated -- contracting about 25 percent in the past year -- a massive uptick in domestic consumption has kept factories producing and growth churning along.
A close examination of retail sales and GDP growth, however, tells a different story. China's domestic retail sales have risen about 15 percent year on year, but that does not really translate into Chinese consumers purchasing 15 percent more televisions and T-shirts. The country tabulates sales when a factory ships units to a retailer, meaning China includes unused or warehoused inventory in its consumption data. There is ample evidence that state-owned enterprises buy goods from one another, simply shifting products back and forth, and that those transactions count as retail sales in national statistics.
China's retail statistics seem implausible for other reasons, too. They would imply an increase in salaries among Chinese people, allowing them to purchase that extra 15 percent. To be sure, the Statistics Bureau reported salaries had increased 12.9 percent in the first half of 2009. But Chinese netizens complained such numbers were hard to believe -- as did the bureau's chief. A look at GDP growth also raises serious questions. China's economy grew at an annualized 6.1 percent rate in the first quarter, and 7.9 percent in the second. Yet electricity usage, a key indicator in industrial growth and a harder metric to manipulate, declined 2.2 percent in the first six months of the year. How could an economy largely dependent on manufacturing grow while its industrial sector shrank?
It couldn't; the numbers don't add up. China announced a $600 billion stimulus package (equal to about 14 percent of GDP) last fall. At that point, local governments started counting the dedicated stimulus funds in GDP statistics -- before finding projects to use the funds, and therefore far before the trillions of yuan started trickling into the economy. Local governments keen to raise their growth and production numbers said they spent stimulus money while still deciding on what to spend it, one economist explained. Thus, China's provincial GDP tabulations add up to far more than the countrywide estimate.
Alternative macroeconomic metrics, such as the purchasing managers' index (PMI), which measures output, offer a no more accurate reflection. One private brokerage house, CLSA, compiles its own PMI, suggesting a sharp contraction in industrial output between December 2008 and March 2009. Beijing's PMI data, on the other hand, indicated that industrial output was expanding during that period. Unfortunately, such obfuscation means China's real economic health is difficult to assess. Most indicators that would help an intrepid economist correct the government numbers -- progress on infrastructure projects, end-user purchases, and the number of "resigned" workers -- are not public.
Still, it is possible to infer the severity of the gap between economic reality and China-on-paper by looking closely at monetary policy. China's state-owned banks dramatically increased lending in the first half of 2009 -- by 34.5 percent year on year, to more than $1 trillion. This move seems intended to keep growth artificially high until exports bounce back. Most analysts agree that it is leading to large bubbles in the stock, real estate, and commodity markets. And the Chinese government recently announced plans to raise capital requirements -- an apparent sign it sees the need to reign in the expansion.
For the long term, China is banking on its main export markets -- in the United States, Europe, and Japan -- recovering and starting to consume again. The hope is that in the meantime, rosy economic figures will placate the masses and stop unrest. But, if the rest of the world does not rebound, China risks the bursting of asset bubbles in property and stocks, declining domestic consumption, and rising unemployment. That's when the Wile E. Coyote moment could happen. Once Chinese citizens no longer believe that the economy is doing well, social unrest and more widespread worker riots -- already increasing in scope and severity -- are likely. That's something that China will have a harder time hiding. And then we'll know whether China's statistical manipulation was a smart move or a disastrous mistake.
Behind FHA Strains, a Push to Lift Housing
As it tried to help shore up the ailing housing market during the past year, the Federal Housing Administration increased its exposure, particularly to mortgages in high-cost states that have also seen some of the sharpest price declines. Now concerns are mounting that the agency -- and the U.S. taxpayer -- may have to pay the price. The FHA insures loans secured with down payments as low as 3.5%. But values in many markets in which it has been increasing its activity have fallen far more than that in the past year. The result: A growing number of homeowners with FHA-backed loans owe more than their homes are worth and are more likely to default.
Officials worry that the resulting losses will help push the FHA's reserves below the level required by Congress. The value of those reserves will be revealed in the agency's annual review due Sept. 30. If they have fallen below the minimum, that could prompt a new round of questions about the role government should play in stabilizing the housing market. David Stevens, the FHA's new commissioner, said on Friday that the agency will continue to support the housing market and isn't in danger of needing a taxpayer bailout. But some housing analysts warn that, if home prices decline much further, the agency would require taxpayer assistance for the first time in its 75-year history.
At the end of June, some 7.8% of FHA-backed loans were 90 days late or more, or in foreclosure, according to the Mortgage Bankers Association, up from 5.4% a year ago. The prospect of yet another taxpayer bailout has put under the spotlight an agency that largely sat out the housing boom. It was created to serve first-time buyers and others with spotty credit. But during the boom, the FHA's rules on such matters as documenting income drove borrowers to lenders with looser standards.
As private lenders sharply curtailed credit when boom turned to bust, the FHA became one of the only places to turn for buyers who couldn't afford big down payments or who wanted to refinance but had little home equity. The number of loans backed by the agency has soared, and its market share reached 23% in the second quarter, up from less than 3% in 2006, according to Inside Mortgage Finance. The FHA's growing role has been cheered by economists, the real-estate industry and members of Congress who felt that it prevented the housing collapse from being worse.
Even as the FHA tightened lending standards moderately last year, Congress allowed the agency to make much larger loans, up to $729,750 in the highest-cost markets. Previous loan limits, at $362,000, had kept the FHA out of more expensive markets, including some of the hardest hit during the housing bubble. In July, California accounted for 13% of the FHA's mortgages, up from 1.5% in 2006. Mounting losses have eaten into the FHA's cash cushion. Federal law says the FHA must maintain, after expected losses, reserves equal to at least 2% of the loans insured by the agency. The ratio last year was around 3%, down from 6.4% in 2007.
FHA officials have refused to comment on whether the reserves would fall below the 2% level, but say that even if that happens, the agency is adequately capitalized. The release of the annual review will be an early trial-by-fire for Mr. Stevens, a well-regarded housing-industry veteran who took the top FHA job in July. Mr. Stevens already has begun boosting oversight and reining in risk. Last month, he suspended Taylor, Bean & Whitaker Mortgage Corp., the third largest FHA lender, from making FHA-backed loans, sending a clear signal about the agency's newly aggressive posture. Taylor Bean ceased operations and later filed for bankruptcy protection. The agency is expected to announce measures this fall to improve oversight of its lenders and will name a chief risk officer, which it has never had.
Some housing analysts believe that deep losses could spur even tighter restrictions. "It absolutely changes the political dynamic once you have to ask taxpayers" for money, said Lisa Marquis Jackson, vice president at John Burns Real Estate Consulting in Irvine, Calif. Last month, the consultancy wrote in a note that mounting losses could lead to an "imminent pullback" from the FHA, and the firm has been warning investor and home-builder clients: "Be prepared for this to happen in some way, shape or form." Members of Congress have voiced concerns over the agency's reserves. But many may balk at raising new hurdles for borrowers.
Lehman rise leads bankrupt stock rally
Almost a year after it filed for bankruptcy, the value of Lehman Brothers shares has soared amid a surge in trading activity. Other bankrupt companies – where the value of shares is usually close to zero because equity investors are compensated only after all creditors have been repaid – have also seen a frenzy of trading in the last few days. "People lost so much money last year and they are so desperate to recoup their losses, that they are willing to invest in anything," said Brad Golding, portfolio manager of CRC Financials Opportunity hedge fund in the Cayman Islands. "Everyone wants a lottery ticket."
After Lehman collapsed last September, Barclays Bank and Nomura bought substantial parts of its business. That left a holding company largely containing toxic mortgage assets and derivatives potentially amounting to billions of dollars that are still being unwound. Lehman shares peaked last week at 32 cents, having spent much of the year at less than 5 cents. When the rally in Lehman began in late August, trading volume soared above 100m shares on one day, compared with virtually no activity earlier in the year. Lehman shares closed last week at 14 cents with trading volumes on Friday reaching just over 11m shares.
Shares in Washington Mutual and IndyMac, two other bankrupt financial institutions, have also risen sharply in recent days. Traders say Lehman and WaMu have more debt than cash, meaning they have no equity value and that buying their shares is a forlorn cause. "It is tulip mania," said Mr Golding. "People have decided [a stock] is worth something based on nothing. The facts are quite the contrary."
Trading in the delisted stocks of companies that have filed for bankruptcy takes place in private, over-the-counter deals, rather than on a registered exchange. More often that not, a sharp rise in the stock price of a bankrupt company reflects speculation about the recovery value prospects. The rally in Lehman shares has followed explosive rises in the share price of Fannie Mae and Freddie Mac, the two mortgage companies taken over by the US government last year. Shares in AIG and to a lesser extent Citi, two companies with significant US government ownership, have also risen sharply in recent weeks.
Labor Day Special: Reward Real Work, Tax Fantasy Finance
"If you want to stop excessive pay in a swollen financial sector you have to reduce the size of that sector or apply special taxes to its pre-remuneration profit."
--Lord Adair Turner, Britain's chief financial regulator.
"The big disadvantage of most taxes is that they discourage some really productive activity. This [Wall Street transaction tax] would discourage numerous financial transactions. People flip their assets several times in an hour or a day. They make money but does it really add to the productive base of the United States?"
--Thea Lee, AFL-CIO Policy Director
Every working American knows the difference between going to work and going to Vegas... unless you're on Wall Street. There you can pretend that pure speculative activity (that produces no real economic value) should be the most highly rewarded activity in the world -- higher than any other occupation, ever. A year has past since this selfish fantasy crashed into a tragic toxic stew, sending nearly 30 million from full-time jobs to the unemployment lines or to part-time work. Yet, we still have failed to put a lid on fantasy finance.
We were fools to let the casino engulf nearly a quarter of our economy in the first place. And we'll be even bigger fools if we miss this moment to slap a tax on all financial transactions, the very best tool we have to reign in Wall Street's destructive excesses. So far, very few of us seem willing to step out on this issue. But over the last week, there have been unexpected rumblings as Britain's chief regulator, an aristocratic Lord no less, along with the AFL-CIO issued nearly identical calls in behalf of a financial transactions tax. Maybe these strange bedfellows can wake us up from our stupor and ignite a serious discussion about the necessity of what was once called a "Tobin Tax".
James Tobin, the late Yale economist and Nobel laureate, originally proposed this tax to stifle currency speculation that he believed would engulf the world economy after the Bretton Woods financial agreements collapsed in 1971. Of course, that speculation returned with a vengeance, but nearly all economists and policy makers dismissed Tobin's proposal as a violation of our dominant dogma: free markets know best, always. Since our all-knowing financial markets imploded last fall, I've been howling in the wind in behalf of such a tax for the same reasons suggested by Thea Lee and Lord Turner. (Forgive me for pointing you to Chapter 10 of The Looting of America).
First, unlike payroll taxes that can discourage businesses from hiring people, we're dealing with the fact that there's too much useless activity going on in the financial sector. Flipping all those assets back and forth does nothing to promote the productivity of the real economy and, in fact, creates a crash-prone system that causes massive unemployment. Flipping toxic assets is more like dumping toxic waste into our rivers -- it might be profitable for a few, but overall it's tremendously harmful. So we want to discourage too much useless financial activity, and a tax on financial transactions helps reign in the sector's excesses.
Second, we need to siphon profits out of the "swollen" financial sector and to put downward pressure on outrageous, unconscionable and totally unjustified Wall Street profits and pay. Even more importantly, if Wall Street didn't have so much money at its disposal, it would have less influence over our elected officials, and would not be able to skew the regulatory process with a multi-million-dollar revolving door between the financial industry and government agencies. If the G-20 nations decided to bring the hammer down on this tax, it would raise hundreds of billions of dollars per year. (The estimated take for the U.S. alone would be at least $50 billion a year and almost all of it would come from the Wall Street firms and hedge funds that engage in repeated high speed trading.)
But this kind of bill will never see the light of day unless we build a broad populist movement to demand it. A poster-child for any campaign should be Andrew J. Hall, who hopes to waltz off with a $100 million payday from Citigroup, a bank which survives entirely because of taxpayer largess. Hall, a successful oil speculator and trader who produces no discernible value for the economy, has a contract that would be worthless had Citigroup gone under, as it certainly was slated to do before we bailed it out. Now he wants his lucre as if he had courageously sailed through the storm on his own. In fact, some view him as a hero to the taxpayer because his speculative profits are helping CitiGroup get out of the red. For me, it's hard to view this as anything other than financial insanity.
Instead of justifying this outrageous rip-off and the many more to come, we should support Representative Peter DeFazio's efforts to tax financial transactions. He has two bills in Congress that could help rebuild our economy. HR 1068 taxes financial transactions to repay us for TARP funds. A second bill just proposed calls for "a transaction tax on crude oil securities to pay for the deficiency in the Highway Trust Fund and to pay for the Surface Transportation Authorization Act of 2009." (link) But due to benign neglect by congressional leaders and the rest of us, these efforts have gone nowhere.
While Europe seems more willing to reign in its bankers, on this side of the pond Wall Street is regrouping rapidly. The higher the stock market, the more boldly Wall Street marches backward towards record profits and renewed sky-high salaries. Seeing no serious opposition, the banking community is using taxpayer support to fund lobbyists to kill any and all legislation aimed at curbing their powers. They will gut the proposed Financial Consumer Protection Agency. They will make sure that the most profitable derivatives will be exempt from controls. They will undercut any and all efforts to curb windfall profits. And of course they will undermine serious attempts to curb their obscene levels of pay.
Not only is this a missed opportunity and a travesty of justice, but it is an economic disaster in the making. Lord Turner and the AFL-CIO are calling for a transaction tax in order to help head off the next crisis which is inevitable unless the system is reformed. They know that if you let wealth accumulate in the hands of the few, you will get a fantasy finance casino. You can regulate all you want but that casino will continue to emerge through the cracks. The only stable solution is to move money out of the bulbous financial sector into the real economy, and to move money from the super-rich to the middle and the bottom of the income ladder. A financial transaction tax is an excellent way to accomplish just that.
It's hard to figure out why more of us aren't up in arms over this. Maybe we feel intimidated by the way banks work. Maybe we have a secret admiration for those who pay themselves tens of millions of dollars (using our tax dollars). Maybe we think the crisis is over and we can go back to business as usual. Or, maybe we think the tooth fairy will come and rescue us. I really don't know. But this is the best moment since the 1930s to do something about our obscene mal-distribution of wealth and our ruinous, bloated financial sector.
We fought a war of independence to free us from aristocratic rule. Now an aristocracy of wealth is taking over, again, even after we watched it wreck the entire economy. If a British Lord and the AFL-CIO can agree to take on this elite, maybe we do have a little something to celebrate on this Labor Day.
Teenage Jobless Rate Reaches Record High
Pity the unemployed, but pity especially the young and unemployed. This August, the teenage unemployment rate — that is, the percentage of teenagers who wanted a job who could not find one — was 25.5 percent, its highest level since the government began keeping track of such statistics in 1948. Likewise, the percentage of teenagers over all who were working was at its lowest level in recorded history.
"There are an amazing number of kids out there looking for work," said Andrew M. Sum, an economics professor at Northeastern University. "And given that unemployment is a lagging indicator, and young people’s unemployment even lags behind the rest of unemployment, we’re going to see a lot of kids of out work for a long, long, long, long time." Recessions disproportionately hurt America’s youngest and most inexperienced workers, who are often the first to be laid off and the last to be rehired. Jobs for youth also never recovered after the last recession, in 2001.
But this August found more than a quarter of the teenagers in the job market unable to find work, an unemployment rate nearly three times that of the nonteenage population (9 percent), and nearly four times that of workers over 55 (6.8 percent, also a record high for that age group). An estimated 1.64 million people ages 16-19 were unemployed. Many companies that rely on seasonal business, like leisure and hospitality, held the line and hired fewer workers this summer — a particular problem for teenagers.
In Miami, 18-year-old Rony Bonilla spent past summers busing tables at restaurants and working at the Miami Seaquarium. He said he set out to find another job this summer, but dozens of businesses, like Walgreens, Kmart and Chuck-E-Cheese, turned him down. Mr. Bonilla said he and many of his friends were unable to find any job offers beyond commission-only employment scams. "I’m looking for anything to pay the bills," he said. "You name it, I applied. And I never even heard from them."
Expecting record unemployment among youth, Congress set aside $1.2 billion in February’s stimulus bill for youth jobs and training. As with everything stimulus-related, supporters, like Jonathan Larsen of the National Youth Employment Coalition, say the money has tempered a bad situation, although the overall numbers are dismal. Economists say there are multiple explanations for why young workers have suffered so much in this downturn, but they mostly boil down to being at the bottom of the totem pole.
Recent college graduates, unable to find higher-paying jobs, are working at places like Starbucks and Gap, taking jobs once held by their younger peers. Half of college graduates under age 25 are in jobs that do not require college degrees, the highest portion in at least 18 years, Mr. Sum said. Likewise, the reluctance or inability of older workers to retire has led to less attrition and fewer opportunities for workers to move up a rung and make room for new workers at the bottom of the corporate ladder.
Increases in the minimum wage may have made employers reluctant to hire teenagers, said Marvin H. Kosters, a resident scholar emeritus at the American Enterprise Institute. High teenage jobless rates may also be distorted by other factors. The ability of more young people to rely on family may allow them to be pickier about jobs and therefore to stay out of work longer than they did in previous recessions, said Dean Baker, co-director of the Center for Economic and Policy Research. Additionally, with more students applying to college, the remaining pool of job applicants may be less desirable to employers.
"Maybe the most employable kids pull out of the labor force, making the numbers for what percent of kids are looking for jobs appear even worse," said Harry J. Holzer, an economist at Georgetown University and the Urban Institute. The decision of more young people to attend college, which could help them increase their earning potential later in life, may be one silver lining of the recession, economists say. Similarly, back when graduating from high school was a rarer achievement, the Great Depression pushed potential dropouts to stay in high school because work was so hard to come by.
But there is a bit of a catch-22: Many college students need to work to pay for college. Half of traditional-age college students work 20 hours a week, Lawrence F. Katz, an economics professor at Harvard, said. "In today’s labor market, the big margin comes from going on to college, not just graduating high school," he said. "Unlike the decision to finish high school, that’s not something you can do free of tuition."
U.S. Recovery Leaving Workers Jobless May Spur Company Profits
Employers kept Americans’ working hours near a record low in August, signaling that economic growth is poised to reward companies with added profits while postponing any recovery in the job market. The average workweek held at 33.1 hours, six minutes from the 33 hours in June that was the lowest since records began in 1964, the Labor Department said yesterday. The report also showed that while payrolls fell by the least since August 2008, the unemployment rate rose to a 26-year high of 9.7 percent.
The preconditions for gains in payrolls, including giving the army of part-timers longer hours and taking on additional temporary employees, weren’t met last month. At the same time, with economic growth forecast to resume this quarter, the figures set the stage for a surge in worker productivity and drop in labor costs that will stoke corporate profits. "It’s disappointing and it tells us that we are not quite there yet," said Michael Feroli, an economist at JPMorgan Chase & Co. in New York who used to work at the Federal Reserve. "It’s great for business and terrible for households" for coming months, Feroli said.
There were almost 9.1 million Americans working part-time last month who would rather have a full-time job, up 278,000 from July, yesterday’s report showed. It almost matched May’s reading, when it reached the highest level since records began in 1955. The index of total hours worked, which takes into account changes in payrolls and the workweek, fell 0.3 percent last month to the lowest level since 2003. "It tells us payrolls aren’t turning positive any time soon," Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities Inc. in New York, said on a conference call yesterday, referring to the workweek figures. "This wasn’t a friendly report."
A measure of unemployment, which includes the part-time workers who would prefer a full-time position and people who want work but have given up looking, reached 16.8 percent last month, the highest level in data going back to 1994. The workweek for factory employees, which held at 39.8 hours last month, leads total payrolls by about three months, LaVorgna said. Once it reaches at least 41 hours and once payrolls for temporary workers stabilize, then an increase in total employment can be expected months later, he said. Payrolls for temporary workers started turning down in January 2007, 11 months before the recession began. They dropped by another 6,500 workers in August, the government’s report showed yesterday.
At the same time, the report did underscore that the economy is on the mend and pulling out of the deepest recession since the 1930s. The drop in payrolls slowed for the sixth time in seven months, to 216,000 in August. Declines in temporary jobs have also slowed in recent months. Companies cut 90,400 temporary staff in November of last year. It’s a step in the right direction, Tig Gilliam, chief executive officer of Adecco Group North America, said in an interview. "That has to happen first," he said. "That is a pre-indicator for improvement in the overall market." Adecco SA, based in Glattbrugg, Switzerland, is the world’s largest supplier of temporary workers.
Gilliam projects the U.S. economy will not start adding jobs until early 2010 and that unemployment will reach at least 10 percent next year. The jobless rate climbed to 9.7 percent last month, the highest level since 1983, from 9.4 percent in July, yesterday’s report showed. Total hours worked are down at a 2.8 percent annual pace so far this quarter, according to calculations by Ian Morris, chief U.S. economist at HSBC Securities USA Inc. in New York. Morris, who projects the economy will expand at a 4 percent to 6 percent pace this quarter, says that means worker productivity may exceed the second quarter’s 6.6 percent jump, which was the biggest gain in almost six years. "This is set to flow straight into the corporate bottom line," he said in an e-mail to clients. That indicates the "strong" earnings for companies in the Standard & Poor’s 500 Index in the three months to June will continue this quarter, he said.
Wall Street Pursues Profit in Bundles of Life Insurance
After the mortgage business imploded last year, Wall Street investment banks began searching for another big idea to make money. They think they may have found one. The bankers plan to buy "life settlements," life insurance policies that ill and elderly people sell for cash — $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to "securitize" these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.
The earlier the policyholder dies, the bigger the return — though if people live longer than expected, investors could get poor returns or even lose money. Either way, Wall Street would profit by pocketing sizable fees for creating the bonds, reselling them and subsequently trading them. But some who have studied life settlements warn that insurers might have to raise premiums in the short term if they end up having to pay out more death claims than they had anticipated.
The idea is still in the planning stages. But already "our phones have been ringing off the hook with inquiries," says Kathleen Tillwitz, a senior vice president at DBRS, which gives risk ratings to investments and is reviewing nine proposals for life-insurance securitizations from private investors and financial firms, including Credit Suisse. "We’re hoping to get a herd stampeding after the first offering," said one investment banker not authorized to speak to the news media.
In the aftermath of the financial meltdown, exotic investments dreamed up by Wall Street got much of the blame. It was not just subprime mortgage securities but an array of products — credit-default swaps, structured investment vehicles, collateralized debt obligations — that proved far riskier than anticipated. The debacle gave financial wizardry a bad name generally, but not on Wall Street. Even as Washington debates increased financial regulation, bankers are scurrying to concoct new products.
In addition to securitizing life settlements, for example, some banks are repackaging their money-losing securities into higher-rated ones, called re-remics (re-securitization of real estate mortgage investment conduits). Morgan Stanley says at least $30 billion in residential re-remics have been done this year. Financial innovation can be good, of course, by lowering the cost of borrowing for everyone, giving consumers more investment choices and, more broadly, by helping the economy to grow. And the proponents of securitizing life settlements say it would benefit people who want to cash out their policies while they are alive.
But some are dismayed by Wall Street’s quick return to its old ways, chasing profits with complicated new products. "It’s bittersweet," said James D. Cox, a professor of corporate and securities law at Duke University. "The sweet part is there are investors interested in exotic products created by underwriters who make large fees and rating agencies who then get paid to confer ratings. The bitter part is it’s a return to the good old days."
Indeed, what is good for Wall Street could be bad for the insurance industry, and perhaps for customers, too. That is because policyholders often let their life insurance lapse before they die, for a variety of reasons — their children grow up and no longer need the financial protection, or the premiums become too expensive. When that happens, the insurer does not have to make a payout. But if a policy is purchased and packaged into a security, investors will keep paying the premiums that might have been abandoned; as a result, more policies will stay in force, ensuring more payouts over time and less money for the insurance companies.
"When they set their premiums they were basing them on assumptions that were wrong," said Neil A. Doherty, a professor at Wharton who has studied life settlements. Indeed, Mr. Doherty says that in reaction to widespread securitization, insurers most likely would have to raise the premiums on new life policies. Critics of life settlements believe "this defeats the idea of what life insurance is supposed to be," said Steven Weisbart, senior vice president and chief economist for the Insurance Information Institute, a trade group. "It’s not an investment product, a gambling product."
Undeterred, Wall Street is racing ahead for a simple reason: With $26 trillion of life insurance policies in force in the United States, the market could be huge. Not all policyholders would be interested in selling their policies, of course. And investors are not interested in healthy people’s policies because they would have to pay those premiums for too long, reducing profits on the investment. But even if a small fraction of policy holders do sell them, some in the industry predict the market could reach $500 billion. That would help Wall Street offset the loss of revenue from the collapse of the United States residential mortgage securities market, to $169 billion so far this year from a peak of $941 billion in 2005, according to Dealogic, a firm that tracks financial data.
Some financial firms are moving to outpace their rivals. Credit Suisse, for example, is in effect building a financial assembly line to buy large numbers of life insurance policies, package and resell them — just as Wall Street firms did with subprime securities. The bank bought a company that originates life settlements, and it has set up a group dedicated to structuring deals and one to sell the products. Goldman Sachs has developed a tradable index of life settlements, enabling investors to bet on whether people will live longer than expected or die sooner than planned. The index is similar to tradable stock market indices that allow investors to bet on the overall direction of the market without buying stocks.
Spokesmen for Credit Suisse and Goldman Sachs declined to comment. If Wall Street succeeds in securitizing life insurance policies, it would take a controversial business — the buying and selling of policies — that has been around on a smaller scale for a couple of decades and potentially increase it drastically. Defenders of life settlements argue that creating a market to allow the ill or elderly to sell their policies for cash is a public service. Insurance companies, they note, offer only a "cash surrender value," typically at a small fraction of the death benefit, when a policyholder wants to cash out, even after paying large premiums for many years.
Enter life settlement companies. Depending on various factors, they will pay 20 to 200 percent more than the surrender value an insurer would pay. But the industry has been plagued by fraud complaints. State insurance regulators, hamstrung by a patchwork of laws and regulations, have criticized life settlement brokers for coercing the ill and elderly to take out policies with the sole purpose of selling them back to the brokers, called "stranger-owned life insurance."
In 2006, while he was New York attorney general, Eliot Spitzer sued Coventry, one of the largest life settlement companies, accusing it of engaging in bid-rigging with rivals to keep down prices offered to people who wanted to sell their policies. The case is continuing. "Predators in the life settlement market have the motive, means and, if left unchecked by legislators and regulators and by their own community, the opportunity to take advantage of seniors," Stephan Leimberg, co-author of a book on life settlements, testified at a Senate Special Committee on Aging last April.
In addition to fraud, there is another potential risk for investors: that some people could live far longer than expected. It is not just a hypothetical risk. That is what happened in the 1980s, when new treatments prolonged the life of AIDS patients. Investors who bought their policies on the expectation that the most victims would die within two years ended up losing money. It happened again last fall when companies that calculate life expectancy determined that people were living longer.
The challenge for Wall Street is to make securitized life insurance policies more predictable — and, ideally, safer — investments. And for any securitized bond to interest big investors, a seal of approval is needed from a credit rating agency that measures the level of risk. In many ways, banks are seeking to replicate the model of subprime mortgage securities, which became popular after ratings agencies bestowed on them the comfort of a top-tier, triple-A rating. An individual mortgage to a home buyer with poor credit might have been considered risky, because of the possibility of default; but packaging lots of mortgages together limited risk, the theory went, because it was unlikely many would default at the same time.
While that idea was, in retrospect, badly flawed, Wall Street is convinced that it can solve the risk riddle with securitized life settlement policies. That is why bankers from Credit Suisse and Goldman Sachs have been visiting DBRS, a little known rating agency in lower Manhattan. In early 2008, the firm published criteria for ways to securitize a life settlements portfolio so that the risks were minimized.
Interest poured in. Hedge funds that have acquired life settlements, for example, are keen to buy and sell policies more easily, so they can cash out both on investments that are losing money and on ones that are profitable. Wall Street banks, beaten down by the financial crisis, are looking to get their securitization machines humming again. Ms. Tillwitz, an executive overseeing the project for DBRS, said the firm spent nine months getting comfortable with the myriad risks associated with rating a pool of life settlements.
Could a way be found to protect against possible fraud by agents buying insurance policies and reselling them — to avoid problems like those in the subprime mortgage market, where some brokers made fraudulent loans that ended up in packages of securities sold to investors? How could investors be assured that the policies were legitimately acquired, so that the payouts would not be disputed when the original policyholder died? And how could they make sure that policies being bought were legally sellable, given that some states prohibit the sale of policies until they have been in force two to five years?
To help understand how to manage these risks, Ms. Tillwitz and her colleague Jan Buckler — a mathematics whiz with a Ph.D. in nuclear engineering — traveled the world visiting firms that handle life settlements. "We do not want to rate a deal that blows up," Ms. Tillwitz said. The solution? A bond made up of life settlements would ideally have policies from people with a range of diseases — leukemia, lung cancer, heart disease, breast cancer, diabetes, Alzheimer’s. That is because if too many people with leukemia are in the securitization portfolio, and a cure is developed, the value of the bond would plummet.
As an added precaution, DBRS would run background checks on all issuers. Also, a range of quality of life insurers would have to be included. To test how different mixes of policies would perform, Mr. Buckler has run computer simulations to show what would happen to returns if people lived significantly longer than expected. But even with a math whiz calculating every possibility, some risks may not be apparent until after the fact. How can a computer accurately predict what would happen if health reform passed, for example, and better care for a large number of Americans meant that people generally started living longer? Or if a magic-bullet cure for all types of cancer was developed?
If the computer models were wrong, investors could lose a lot of money. As unlikely as those assumptions may seem, that is effectively what happened with many securitized subprime loans that were given triple-A ratings. Investment banks that sold these securities sought to lower the risks by, among other things, packaging mortgages from different regions and with differing credit levels of the borrowers. They thought that if house prices dropped in one region — say Florida, causing widespread defaults in that part of the portfolio — it was highly unlikely that they would fall at the same time in, say, California.
Indeed, economists noted that historically, housing prices had fallen regionally but never nationwide. When they did fall nationwide, investors lost hundreds of billions of dollars. Both Standard & Poor’s and Moody’s, which gave out many triple-A ratings and were burned by that experience, are approaching life settlements with greater caution. Standard & Poor’s, which rated a similar deal called Dignity Partners in the 1990s, declined to comment on its plans. Moody’s said it has been approached by financial firms interested in securitizing life settlements, but has not yet seen a portfolio of policies that meets its standards.
Despite the mortgage debacle, investors like Andrew Terrell are intrigued. Mr. Terrell was the co-head of Bear Stearns’s longevity and mortality desk — which traded unrated portfolios of life settlements — and later worked at Goldman Sachs’s Institutional Life Companies, a venture that was introducing a trading platform for life settlements. He thinks securitized life policies have big potential, explaining that investors who want to spread their risks are constantly looking for new investments that do not move in tandem with their other investments. "It’s an interesting asset class because it’s less correlated to the rest of the market than other asset classes," Mr. Terrell said.
Some academics who have studied life settlement securitization agree it is a good idea. One difference, they concur, is that death is not correlated to the rise and fall of stocks. "These assets do not have risks that are difficult to estimate and they are not, for the most part, exposed to broader economic risks," said Joshua Coval, a professor of finance at the Harvard Business School. "By pooling and tranching, you are not amplifying systemic risks in the underlying assets."
The insurance industry is girding for a fight. "Just as all mortgage providers have been tarred by subprime mortgages, so too is the concern that all life insurance companies would be tarred with the brush of subprime life insurance settlements," said Michael Lovendusky, vice president and associate general counsel of the American Council of Life Insurers, a trade group that represents life insurance companies.
And the industry may find allies in government. Among those expressing concern about life settlements at the Senate committee hearing in April were insurance regulators from Florida and Illinois, who argued that regulation was inadequate. "The securitization of life settlements adds another element of possible risk to an industry that is already in need of enhanced regulations, more transparency and consumer safeguards," said Senator Herb Kohl, the Democrat from Wisconsin who is chairman of the Special Committee on Aging. DBRS agrees on the need to be careful. "We want this market to flourish in a safe way," Ms. Tillwitz said.
Banks Need to End $1 Trillion Kick the Can Game
Banks have known for a while that they would eventually have to face up to some of the assets they had stashed in off-balance-sheet vehicles. Now that day is looming, and regulators are concerned that lenders might need even more time to deal with such items. Enough already. It’s time for banks, and their regulators, to stop playing kick the can. Either banks have -- or can get -- the capital they need to support assets on their books, or government watchdogs should take action.
Instead, regulators last week raised the prospect of giving banks a one-year, phase-in period to fully recognize for capital purposes what may be about $1 trillion in assets coming back onto balance sheets next year. This breathing room may ostensibly help some banks avoid having to quickly beef up regulatory capital, the buffer that helps them absorb losses. Such a delay is unwarranted. Banks have had almost two years to prepare for accounting-rule changes adopted this spring that will place greater restrictions on the use of off-balance- sheet vehicles. And it was just such hemming and hawing that helped get the banking system into its current mess. After the implosion of Enron Corp., accounting-rule makers tried to shut down off- balance-sheet games.
Banks fought back, and the Financial Accounting Standards Board watered down the restrictions. That helped fuel both the rise of off-balance-sheet lending vehicles during the credit- bubble years as well as the so-called shadow-banking system. These vehicles allowed banks to shuffle assets off their books -- everything from mortgages to credit-card debts to auto loans -- even though they often still bore some risks from them. By seemingly shedding these assets, banks were able to hold less capital. That helped boost returns and profit. It also allowed risks to build up out of the sight of investors, regulators and in some cases the banks themselves.
As Federal Deposit Insurance Corp. Chairman Sheila Bairsaid in an op-ed article in the New York Times this week, "the principal enablers of our current difficulties were institutions that took on enormous risk by exploiting regulatory gaps between banks and the non-bank shadow financial system." Those gaps were exposed when the financial crisis hit, and many banks were saddled with assets, and losses, from those previously out-of-sight, off-balance-sheet vehicles. The best- known case involved Citigroup Inc., which suddenly had to absorb about $25 billion in collateralized debt obligations.
Even smaller banks such as Zions Bancorporation had to help off-balance-sheet vehicles, straining already-stretched balance sheets. This spring, the FASB tightened the rules. In light of that, bank regulators -- the FDIC, Office of the Comptroller of the Currency, the Federal Reserve and the Office of Thrift Supervision -- have to decide how these returning assets will be treated for capital purposes. Regulators allow banks to hold different amounts of capital against different kinds of assets, which is why regulatory capital can differ from a bank’s stated shareholder equity, or net worth. Those deliberations gave rise to the possibility of the year-long phase-in period. A year may not seem like a long time; it is certainly less than the three-year grace period sought by some banks.
Yet regulators, including the FDIC’s Bair, acknowledge that the new accounting rules are needed. More than that, in a television interview last week, Bair said if banks had faced stricter treatment for off-balance-sheet vehicles "a few years ago, I think there would have been more capital in the system." If these rules would have helped to prevent the current crisis, that is all the more reason not to dilly-dally. Bair and other regulators haven’t said whether they would support a phasing-in of capital requirements. Bair has said, though, the 2010 start date for the new rules "is a little troublesome." Big banks in particular should have to face up to reality from the get-go since the government’s stress tests of 19 large institutions acted as if about $700 billion in off-balance-sheet assets had already returned.
The big four banks -- Citigroup, JPMorgan Chase & Co.,Bank of America Corp. and Wells Fargo & Co. -- are expected to see about $550 billion in assets return to their books under the accounting-rule changes, Barclays Capital analyst Jason Goldberg estimated in a recent report. Besides having had time to prepare for the changes, there is another reason to avoid delay. Any postponement opens the possibility that banks will use the phase-in period to argue for further forbearance. That is a time-honored tradition in Washington -- if you can’t kill something outright, just delay it into oblivion. Bank lobbyists shouldn’t be given that chance. Banks need to take their off-balance-sheet medicine now, without delay.
Construction Loans Falter, a Bad Omen for Banks
Even as the economy may be starting to recover, banks across the country are confronting a worsening outlook for their construction loans, an area that boomed for much of the decade. Reports filed by banks with the Federal Deposit Insurance Corporation indicate that at the end of June about one-sixth of all construction loans were in trouble. With more than half a trillion dollars in such loans outstanding, that represents a source of major losses for banks.
Construction loans were highly attractive in recent years for many banks, particularly smaller ones without a national presence. One reason was that other types of loans were not easy to make. A handful of big banks came to dominate credit card loans, for example, and corporate loans were often turned into securities. Construction loans, however, needed local expertise and were not easy to standardize. In a booming real estate market, there were few losses on such loans.
The problems now extend well beyond loans for the construction of single-family homes, where banks have been taking losses and cutting back their commitments for a couple of years. At the end of June, $173 billion in construction loans related to single-family homes was outstanding, barely more than half the peak level reached in the fall of 2006, when the housing market was booming. It is in commercial real estate construction — be it stores or office buildings — that the pain seems likely to rise. At the end of June, $291 billion in such loans was outstanding, down only a few billion from the peak reached earlier this year.
"On the commercial side," said Matthew Anderson, a partner in Foresight Analytics, a research firm based in Oakland, Calif., "I think we are fairly early in the down cycle." Foresight estimates that 10.4 percent of commercial construction loans are troubled, but expects that to increase as the year goes on. The definition of troubled loans used in the accompanying charts includes loans that are at least 30 days past due, as well as those on which the bank identified problems that led it to stop assuming that interest on the loans would be paid.
It is possible that some of the rapid rise in problem loans represents pressure from regulators to admit problems, rather than new problems. The number of newly delinquent loans seems to have declined in the second quarter, although it is hard to know if that is a trend that can continue. But the number of loans that the banks do not expect will be fully repaid has soared. The reports that banks file with the F.D.I.C. do not include details on all types of construction loans, nor on where the construction is. That information is estimated by Foresight, based in part on where each bank operates and on disclosures in other company reports.
Foresight estimates the biggest problems are in loans for condominium construction, with 38 percent of all construction loans troubled. Mr. Anderson says even that might be an understatement. He pointed to Corus Bank, a Chicago institution that specialized in condo loans. Its latest report shows that its capital is gone and that it expects losses on two-thirds of its construction loans. Foresight’s estimates of the proportion of problem construction loans in the 20 largest metropolitan areas has one surprise: the one with the largest proportion of troubled loans is Seattle, where the recession has started to pinch. But it is also notable that just one of the 20 areas has less than 10 percent of construction loans in trouble. A year earlier, most of them were below that level.
Europe split over U.S. bank capital plans
Continental European officials defended the globally-agreed Basel II capital rules for banks on Friday despite a U.S. call for its effective replacement with a tougher new regime within three years. Britain and Canada offered broad support for U.S. Treasury Secretary Timothy Geithner's plan for a radical reform so that banks set aside enough capital to avoid a rerun of the government bailouts during the credit crunch.
But France and Germany were cool as they pushed for more countries to adopt the Basel II rules in full, something which the United States has resisted. Geithner wants the new framework to be broader and tougher, requiring banks to hold more capital and be in place by the end of 2012 -- an ambitious target as Basel II took a decade to thrash out. He was due to present his proposal to a meeting of G20 finance ministers in London on Friday and Saturday but was already meeting some opposition.
French Economy Minister, Christine Lagarde, said revisions to Basel II would ensure banks have sufficient capital, and suggested that simply a "good and sound" explanation of what Basel II was needed to persuade G20 ministers it was enough. "It has been significantly improved, amended over time to take into account the... liquidity principle that was not part of the Basel II solution," Lagarde told reporters on the sidelines of the G20 meeting.
"I think we need to see clearly what is the problem, where is the issue, and what is the position of Basel II as amended before we jump to any new rules." A G7 source said Germany was also wary and a board member of its biggest bank, Hugo Banziger of Deutsche Bank, said Basel II did not need replacing. "There is absolutely no reason why that should be replaced... Basel II is a very good platform. Minor things need to be adjusted and other things need to be developed," Banziger told a Bank of France panel discussion.
European Central Bank Governing Council Members Christian Noyer and Nout Wellink said in a Bank of France report on regulation that planned refinements to Basel II would lead to improvements.
"Blaming Basel II is certainly short-sighted. If we should blame something, we should blame Basel I," Noyer said. "I am not taking from what (Geithner) said that it is against Basel II. I think the problems he raises are to a large extent addressed now by the Basel Committee."
British Finance Minister, Alistair Darling told Reuters in an interview he agreed with the United States that, across the world, banks needed to strengthen their capital position. "Inevitably, different countries have different emphases. It's very important that people recognise that the capital positions of banks have to be strengthened. It's important that we see all of these proposals as a whole."
Canada's Finance Minister, Jim Flaherty, also offered broad support for Geithner's proposal. "Certainly we have common cause with the U.S. With respect to capitalization requirements. Without being immodest, these kinds of recommendations have the world converging toward the Canadian position," Flaherty told reporters.
But Nout Wellink, who is also chairman of the Basel Committee on Banking Supervision which drafted the Basel II rules, said in the Bank of France report that changes to Basel II would make markets safer. "Taken together, the recent and planned initiatives of the Basel Committee will promote a more robust banking sector and limit the risk that weaknesses in banks amplify shocks between the financial and real sectors," Wellink said.
Noyer said more changes were needed to address the root causes of risks to financial stability, such as monitoring of system wide risks from banks. But there was still no widely accepted method to measure such risk "if this risk is able to be captured", he said.
Obama unveils measures to spur US retirement saving
U.S. President Barack Obama announced new measures on Saturday to encourage Americans to save more money for retirement, a move the White House said would put the economy on a stronger footing in the future. Obama, in his weekly radio and Internet address, said the government would enact rules making it easier for small businesses to let workers automatically enroll in Individual Retirement Accounts (IRAs) and 401(k) retirement plans.
Payments for unused vacation time and sick leave could be converted into retirement savings under the new measures and Americans would be able to have tax refunds directly deposited into their retirement accounts or used to buy savings bonds. The measures do not require congressional approval and most will take effect immediately. "We have to revive this economy and rebuild it stronger than before," Obama said in the address. "And making sure that folks have the opportunity and incentive to save -- for a home or college, for retirement or a rainy day -- is essential to that effort."
As the Obama administration focuses on lifting the U.S. economy out of its worst crisis since the Great Depression, the president has often warned that recovery must be coupled with steps to prevent another financial fall. Americans' widespread reliance on credit cards and failure to save are two things he has targeted as part of that effort. "The fact is, even before this recession hit, the savings rate was essentially zero, while borrowing had risen and credit card debt had increased," Obama said. "We cannot continue on this course. And we certainly cannot go back to an economy based on inflated profits and maxed-out credit cards."
Obama said a drop in housing prices and fall in financial markets had caused Americans to lose some $2 trillion in retirement savings over the last two years. John Boehner, the Republican leader in the House of Representatives, called on Obama to support a Republican initiative that he said would keep the government from hindering Americans' ability to restore their savings. "Republicans are pleased President Obama has joined us in calling for action to help Americans rebuild their lost savings," the House minority leader said in a statement. "Millions of Americans have watched with anxiety in the past year as the value of their 401(k)s, college savings plans and other vital savings accounts have plummeted, and government should not be an impediment as they work to restore what they've lost," he said.
The House Republican bill would raise contribution and catch-up limits for retirement accounts, reduced Social Security earnings penalties, suspend capital gains taxes on newly acquired assets for two years and suspend taxes on dividend income through 2011, among other measures. An administration official said the Net National Savings rate -- which groups personal, corporate and government savings -- was -2.8 percent in the second quarter of 2009. The U.S. personal savings rate came in at 5 percent in the same time period after falling as low as 0.8 percent in April of last year.
"Right now the situation in national savings is unsustainable," said the official, calling the negative net national savings rate a "major macroeconomic challenge." U.S. officials hope making saving mechanisms more automatic will spur Americans to put more money away. Automatic enrollment programs in 401(k) savings plans by big corporations have increased employee participation significantly. "Working Americans should be able to retire with dignity and security, but nearly half of the nation's workforce has little or nothing beyond Social Security benefits to get by on in old age," Treasury Secretary Timothy Geithner said in a statement.
The initiatives announced on Saturday are meant to augment previous proposals that do require congressional approval, including a plan to automatically enroll workers in IRAs if they do not have workplace retirement plans. Even as it urges Americans to save, the administration wants consumers to spend money to help spur economic growth. The legislative proposals on Individual Retirement Accounts would not go into effect for a few years -- until 2011 -- to account for that dual desire, the official said.
Britain heading back to the dark ages
When California was hit with a spate of crippling power cuts eight years ago, it was not simply the fault of an unscrupulous energy supplier called Enron manipulating prices. The power company was blamed for meddling with the market, but state politicians were also forced to admit that their lack of investment in new electricity plants had contributed to the shortages. Rupert Soames, the chief executive of Aggreko, the FTSE 250 emergency power generator, says the UK must prepare seriously for the danger of being hit by similar blackouts within the next decade.
"It has happened before in developed countries and we should not kid ourselves that it cannot happen here," he said in an interview with The Sunday Telegraph. "The UK has an unacceptably high risk of interrupted power supply and I have enormous doubt about whether new plants are going to be built in time." Aggreko has already had to provide emergency power to governments in Spain, Greece, Asia, South America and Africa. Mr Soames does not want to see this happen in the UK, but fears that "a slow train crash" of energy shortages is on its way unless more action is taken.
His fears are not unfounded. It was revealed by The Daily Telegraph earlier this week that the Government's own figures suggest that there will be a 3000 megawatt hour shortage of supply by 2017 causing 1970s-style blackouts.
Over the next 10 years, one third of Britain's power-generating capacity needs to be replaced with cleaner fuels, as a result of European laws on pollution. By 2025 the situation is expected to worsen with the shortfall hitting 7000 megawatt hours per year – the equivalent to an hour-long power cut for half of Britain. Ed Miliband's Department of Energy and Climate Change has swiftly dismissed these ideas as alarmist, arguing that new renewable and gas plants will be able to cope.
Critics point out that the Government is going to have to persuade energy companies or other investors to build thousands of wind turbines, at least three potential new nuclear plants and a raft of cheaper gas stations if demand is to be met. There are fundamental problems with leaving these decisions purely to the market, according Mr Soames. The recession has meant that there is little incentive for private companies to start investing in new stations. And there is a growing sense that EdF, E.ON and RWE npower, the backers of new nuclear plants, may find that construction is uneconomic without levies on consumer bills – something ruled out by the Government.
Mr Soames' biggest worry is that existing nuclear stations may be forced to stay running for longer than is safe, with unknown consequences. Most controversially, the Aggreko boss believes that until the UK makes concrete plans for tackling a shortage of power stations, national energy security ought to take a priority over the targets that say UK emissions must be reduced by 80pc from 1990 levels by 2050. "I personally believe that meeting climate change goals are not incompatible with national energy security in the long run, but I think keeping the country running is more important," he said.
Some even believe that expecting the power to flow seamlessly until 2017 may be unduly optimistic. Nick Campbell, an analyst at the energy consultants Inenco, has calculated that the energy gap could start in 2012 – just three years away and five years earlier than the Government admits. The problem lies in the European Union's decree that Britain's dirtiest power stations – the old-style coal and oil generation plants – must be shut down not at a certain date, but after a certain number of hours. These plants, which are used as back-up generators for times of peak demand, are expected to shut in about 2015.
However, a number of outages at nuclear power plants mean these stations have already been burning through their allocated number of hours far more quickly than forecast. In fact, six out of ten may be forced to stop generation long before they are due to be decommissioned in six years' time. "Alternative forms of generation will need to be online way before these nine coal-fired plants reach their 2015 deadline or the generation gap will occur at some point between 2012 and 2015," said Mr Campbell.
Greg Clark, the shadow energy and climate change secretary, has also pointed out that the scale of the blackouts could be three times worse than Government predictions. Some of the modelling assumes little change in electricity demand until to 2020 and takes for granted a rapid increase in wind farm capacity. Dr Jon Gibbins, an energy technology expert from Imperial College, London, has been warning for years that the country faces an energy crisis, but says the situation is now growing more grave. "The electricity industry has been sweating assets for a long time and now it's just about at the point of running out," he said. "Policies at the moment just look like somebody in a Government office making up numbers."
He is particularly worried that Britain has left it late to start approving new nuclear stations, leaving the country with a glut of gas-fired power stations and intermittent renewable sources for some years. An over-reliance on gas-fired stations also leaves the UK vulnerable to the whims of politically unstable gas-producing regions such as Russia and the Middle East as Britain's North Sea reserves deplete, Dr Gibbins explains. Most will be imported via pipeline from Norway, but extra gas for winter needs to be shipped in expensive liquefied form. "We could be left with only renewables and gas plants for a while," Dr Gibbins said. "There's a distinct possibility that we won't be able to get enough gas. We have been lulled into a false sense of security by low gas prices during the recession, but the trend is that it will get more expensive."
In the long term, electricity demand is only likely to increase. Gas boilers and the transport system will be expected to go electric if the UK has a chance of hitting emissions targets, piling more pressure on the network. Chris Bennett, future transmission manager at National Grid – who is not unduly worried about shortages – is responsible for considering how to "flex demand" as the network operator works out how to balance changing consumption patterns. Smart meters, which monitor how household energy is used, could be used to switch refrigerators on and off, allow washing machines to run at off-peak times and make sure electric cars are charged overnight.
However, sceptics worry that a so-called "intelligent grid" could also be used to ration consumers in the event of insufficient capacity. The power companies themselves are often wary of talking about future supply problems, but some, such as British Gas's owner Centrica, have been buying up North Sea assets in preparation for the "dash for gas". However, E.ON points out that the recession has caused a 4pc drop in demand for electricity, as industrial customers close operations. "We have got an extra five years or so to think about this now," said a spokesman for the power company. "Many manufacturing bases have stopped operating and activity won't return to normal for some time."
Other experts note with a touch of cynicism that it may be in the interests of the big six electricity and gas suppliers to operate with a shortage of electricity. "Electricity providers can make more profits through their trading desks when prices are high than actually selling the power to homes," says one senior source in the energy trading industry. "There is sometimes a conflict of interest here." In the last few months, the Government may slowly have been beginning to move in the right direction. Earlier this year, it widened the remit of the regulator, Ofgem, to include national energy security and promised to speed up the planning process that awards access to the national grid.
Reports from the CBI, the business body, and Malcolm Wicks, Gordon Brown's special representative on energy security, also recognised that Britain needs to start building more nuclear power stations. But while the Government considers these reports and clings to its endless strategy documents, Britain's aged network and power stations lumber towards the end of their lives. "Big infrastructure changes are not a happy country for politics," Mr Soames says. "But somebody needs to take responsibility and realise that renewable energy sources are not going to be enough in the medium term. We need fewer targets and more concrete plans or risk the lights going out over Britain."
British conservatives float plans for massive privatisation
Selling off a range of public bodies would be a "get out of jail card" as the Tories desperately try to balance the books, according to tax lawyer Charlie Elphicke, who has advised the party's economic team.
John Redwood, chair of the Conservatives' economic competitiveness commission, has published proposals on his blog for the sale of Britain's motorway network while Ed Vaizey, the shadow arts minister, last week suggested selling off Radio 1.
The proposals reflect a growing belief behind the scenes that Mr Cameron will have to consider some form of privatisation programme of the type instigated by Margaret Thatcher if he wins power. Beginning soon after she took office in 1979 with the first stage of a sell-off of BP, Lady Thatcher's privatisation programme accelerated in the early 1980s with the successive sales of utility companies. Mr Elphicke, the Tory candidate for Dover, said: "The budget deficit this year and next year is expected to be £180 billion.
"If you reduce spending by £60 billion and put taxes up by £40 billion you still have a huge hole, a massive borrowing overhang. "How do you reduce the level of borrowing and repair the public finances? Asset sales are the one thing that is a get out of jail free card." Mr Elphicke said the Tories should consider selling BBC Worldwide, the commercial arm of the BBC, which could bring in an estimated £8 billion to the Exchequer. He said: "It's a neat little compromise. It preserves the integrity of public service broadcasting and leaves the rest of the BBC intact. The public have poured money into this over the years and we could argue that we now need the money back."
Mr Elphicke said Royal Mail and Channel 4 could also be sold, and banks returned to the private sector. "Even Labour are looking at selling off things like the Dartford Crossing and British Waterways," he said. "And David Cameron has said he wants a discussion about what the state should and should not do. "We need to say 'What does the government own that it does not need to own?' There is a conversation to be had with the nation where we say 'Look, we have to make hard decisions.'" Both Mr Elphicke and Mr Redwood argue that high street banks taken into public ownership during the credit crisis should be part of an early privatisation package.
"If you return the banks to the private sector you get capital receipts of £150 billion. That is the golden hope," Mr Elphicke said. Mr Vaizey was slapped down by party chiefs last month for proposing that the BBC should be forced to sell Radio 1. Although he is the shadow minister responsible for broadcasting, a Tory spokesman said the sale of Radio 1 was not party policy. Mr Vaizey, a long time member of Mr Cameron's inner circle, later said he was only speaking "metaphorically" and was simply giving an illustration of one way in which the dominance of the BBC could be broken up.
However, insiders say the idea of asset sales is being discussed by the Treasury team. One senior Conservative MP said: "We are absolutely fixated with balancing the books now, it is the only thing that matters. "And we are stuck with the fact that we have said we are not going to change the NHS budget and that is a fifth of the whole government budget. So we are stuck with that and we have to look elsewhere. "There is no way we are going to make the books balance just with cuts. Radio 1 and Radio 2 are ripe for a sell-off, perhaps even BBC1. "There is a perfectly sensible economic argument for selling off Royal Mail but it is politically toxic. We need to look at these things." Mr Elphicke said asset sales could be delayed until a few years into a Conservative government to ward off public alarm. "It doesn't need to be done immediately. It can be in year three," he said.
Banks are overvaluing toxic property loans, experts warn
Banks are significantly overvaluing assets to be included in the government's insurance scheme, which could leave the taxpayer footing the bill for any shortfall, experts have warned. Property loans – which will be part of the £575bn government's asset protection scheme (APS) to ring-fence the most toxic assets of Lloyds Banking Group and Royal Bank of Scotland – will be dated as of the end of December 2008 although commercial real estate values have fallen by just over 10% since then, according to data from the consultancy Investment Property Databank.
Matthew Oakeshott, the Liberal Democrat Treasury spokesman, said: "The APS is a ticking time-bomb for the British taxpayer. These poisonous property loans must have an independent, up-to-date valuation in accordance with the Rics [Royal Institution of Chartered Surveyors] valuation 'red book' when taxpayers actually go on the hook. "If not, the APS will be a fraud on the British taxpayer – just like someone insuring a car after it has crashed." Oakeshott is writing a letter to the chancellor, Alistair Darling, raising his concerns about what he called "taxpayers being stung in an APS cover-up". According to him, Britain should follow the Irish government, which is contracting independent valuers to put a price on banks' property loans before they go into a so-called "bad bank".
Governments around the world have designed programmes to insure, protect or ring-fence toxic assets to help re-establish confidence in the financial system and encourage banks to start lending again. RBS is putting about £60bn of commercial property loans into the APS, out of a total £315bn of assets, while Lloyds' property loans in the scheme mount to £90bn, out of an overall £260bn, according to Credit Suisse estimates.
Industry specialists say any insured asset should be priced as realistically as possible. David Lovett, managing director of the restructuring firm Alix Partners, said: "The assets to be transferred should be valued at the date of transfer; it has to be at that date to ensure there is an accurate assessment and the issue has been resolved. "To have a valuation of any other date has the potential for distorting the claim and creating an over- or an underpayment for the claim," he said.
The government and the banks, however, claim the valuation date goes back to the end of last year because that is when coverage of the losses started. The taxpayer will pay 90% of any losses suffered by the two partially nationalised banks after a first loss to be taken by the banks. Ann Cairns, managing director at the restructuring firm Alvarez & Marsal, said: "If the government insured portfolios at today's prices, the insurance would be less expensive for the banks, but the value of that insurance would be limited."
The banks are paying a fee to the government for insuring their toxic assets and analysts differ over whether they will be forced to shoulder losses above that level. The government made a £25bn provision for APS-related losses in the budget. Jonathan Pierce, of Credit Suisse, estimates that the two banks' losses will not surpass the £32bn that the banks are paying the government in fees. However, he added: "This is highly sensitive to small changes in the proportionate loss rate because the amount of assets is so big and the length of time that the assets are covered."
Future losses depend on whether the economy recovers quickly enough, with predictions also varying widely. According to CB Richard Ellis, a real estate consultancy, property prices may only increase by 5% to 10% over five years, short of the near-30% decline in value since the peak of the market. BNP Paribas forecasts a rise of about 30%. Analysts complain that the scheme has so many uncertainties that it is difficult to predict any outcome. Final details are not yet ready, after months of negotiations following the initial announcement in February. A deal may be struck later this month, a source said. Lloyds is also having second thoughts about it and has been sounding out investors about an alternative rights issue.
Analysts agree that the announcement of the scheme helped calm the markets at a time when bank shares were in freefall. But since then, the design of the APS has been slow to take shape and has failed to re-ignite inter-bank lending, critics say. People and firms are still finding it difficult, or expensive, to access finance and encourage economic growth. Simon Adamson, credit analyst at CreditSights, said: "Clearly, it has taken a long time to put together and there are still a lot of doubts about how and when. It helped to restore confidence to banks but in terms of stimulating lending, it doesn't really seem to have achieved much."
Oakeshott believes it would be better to be more realistic and take the pain right away. "Japan's long agony in the 80s and 90s after a property price crash should teach us one single lesson – it's far better to take the pain up front and move on than trying to hide overvalued property off balance sheet for years on end," he said. "Our government must not sweep this £500bn problem under the carpet until after the election."