March 30, 2012 6:06 pm

America’s dream unravels

Barack Obama©AFP
Barack Obama: disputes that the US is in decline

It feels like you are entering a parallel universe. In reality it is just a few short steps down a plank into the neon-lit floating world of a casino ship. The location is Lake Michigan. The town is Gary, Indiana. And the host is the Majestic Star Casino. “Welcome to Majestic Star,” says a croupier. And to post-industrial America, she might add.

Many cities and towns across America have been shattered by the demise of mass employment in manufacturing over the last generation. Few have been hit as hard as Gary – once a thriving hub of steel production, and birthplace of the late Michael Jackson, one of the most successful pop stars in history. Some places, such as Pittsburgh, have become showcases of urban reinvention, partly by making the most of the strong medical legacy left by the departing generation of well-paid union workers (whose “Cadillachealthcare packages spawned a robust hospital system).


Almost every city, including Gary, has dug deep to fund a new sporting stadium. Convention centres are also a staple of America’s formula for urban regeneration. The jury remains out on their impact. In contrast, there is a surprisingly broad consensus among state and city officials across America about the economic virtues of gambling.


Unlike the titans of football and baseball, whose new stadiums swallow huge chunks of local capital budgets, gaming companies only require a licence to gamble and a few tax breaks. It helps if there is a large population centre nearby East Chicago virtually merges with Gary at the Illinois state border line.

It helps even more if there is a pool of able-bodied unemployed people prepared to work for low wages and anaemic benefits. Gary can still offer that. But in spite of all the casinos, its population keeps shrinking. In 1980 it had 145,000 people. That is now down to 80,000. “When I was five years old, my mother would hold my hand when we walked down Broadway because there were so many people,” says Saleem el-Amin, a middle-aged city demolition worker, pointing at the town’s eerily quiet main street.

When asked how many of his friends worked in the casino industry, el-Amin says: “There’s a cousin who works at Ameristar [another hotel casino] as a house-keeper” – meaning a cleaner. In contrast, he knows of plenty of people who wager their surplus cash on the blackjack table or the slot machines.

From Florida to California, and numerous Native American reservations in between, the impact of gambling varies, according to a welter of studies. Some show that the effect on the people around the casinos is a net negative. It can also be bad for tax revenues. One study estimated that for every dollar a gaming house invests in an area, three are subtracted by the costs of dealing with its social effects.

Casinos may be a way of replacing some of the manufacturing jobs lost to China, Brazil and elsewhere. But they are also a magnet for racketeers, pimps, drugs and those living on the margins.

US casino
Casinos: regarded as job creators

In a world where the economic centre of gravity is shifting from west to east, the continued faith in casinos, and other forms of gaming, epitomises a certain bankruptcy of thinking among America’s policy makers. On the charts they show up as service jobs, which economists instinctively treat as superior to jobs that involve making things.

Much like the shift from farming to manufacturing a century ago, America is now climbing up the value-added chain to the more cerebral world of service industries. Brain power is America’s future.

It doesn’t always appear too cerebral in practice. Too large a share of the new service jobs are dead-end and enforced part-time positions that enable the employer to wriggle out of providing healthcare insurance. In the past decade, the number of Americans insured by their employers has fallen from two-thirds to barely half. Only the senior managerial slots offer any real security and they are mostly taken by outsiders. Much the same could be said of the armies of food preparers, domestic carers and data-entry workers who account for so many of the new service jobs America is creating.

“We are on track to becoming a country where the top tier remains wealthy beyond imagination, and the remainder, in one way or another, are working in jobs that help make the lives of the elites more comfortable,” says Harvard’s Lawrence Katz, one of America’s foremost labour economists. “They will be taking care of them in old age, fixing their home WiFi, or their air-conditioning, teaching or helping with their kids and serving them their food. It is not a very elegant prospect.”

. . .

This essay is about how America is coping with its relative economic decline (“relative” because the US will continue to get richer in the aggregate, although at a far slower pace than the rising east). America is a big and awe-inspiringly diverse place. For every shell-shocked Gary, Indiana, or Flint, Michigan, there is a Pittsburgh, Pennsylvania, or a St Louis, Missouri, that is making a better fist of the transition – although their median incomes are still below the national average.

And for every few Garys there is a Palo Alto, the thriving hub of Silicon Valley, where I often stay with my brother-in-law and sister-in-law, who both live there. Its streets may not be paved with gold. But they come close enough. If Dick Whittington arrived in America today, Palo Alto is where he would head. Gary he would avoid.

Software billionaires, such as Larry Ellison of Oracle and Mark Zuckerberg of Facebook, make up an outsized share of the Forbes 400 list of America’s wealthiest. Many of the remainder in the top echelons made their money from hedge funds and Wall Street, such as George Soros and John Paulson. Then there are the retail kings, such as the Walton family, owners of Walmart, whose combined assets equal that of America’s bottom 150 million people.
High up on the list though are people such as Sheldon Adelson, the Las Vegas gaming magnate, and Donald Trump, the real-estate and now reality-TV king, who also has a casino in Gary. Both are heavily involved in the Republican partyAdelson has so far spent $16.5m in support of Newt Gingrich’s doomed presidential aspirations. Trump toyed with his own presidential bid. Both became rich through America’s long-term booms in real estate and gaming. Nor did the good times end in 2007. Adelson’s fortune has jumped by more than a third to $21.5bn since the start of the Great Recession. He is now the eighth richest American (up seven places).

Like so many of his fellow billionaires40 of whom have already contributed heavily in this election, according to Forbes Adelson is prepared to wager a great deal more on candidates who share his belief that government should simply get out of the wayup to $100m in this election, he recently disclosed. Apart from the fact that Indiana’s casinos are legally obliged to stay off dry land, government has already done a good impression of making itself invisible in places like Gary.

Less than an hour’s drive away, in the plush Chicago suburb of Schaumberg, retreating government is precisely what Mitt Romney, Gingrich’s nemesis, is promising to a lacklustre crowd of Illinois supporters. Romney has just won the state primary by a thumping margin, laying to rest anxieties that he will be derailed by Rick Santorum, his latest – and most socially conservative rival in the Republican primary.

Showing the plus side of the “Etch A Sketchadaptability for which he is renowned, Romney has recently updated his stump attack on Barack Obama. Until February, Romney focused on joblessness, which is still above 8 per cent. Now he talks about declining incomes and rising petrol prices.

The switch makes sense: the US economy has added an average of 200,000 jobs a month since October, while median incomes are still declining. The latter are a far better predictor of whether an incumbent president will get re-elected.

But this is an election and Romney is speaking in soundbites. Around the extended stage, which takes up a quarter of the ballroom floor, there are about 300 well-dressed supporters, many of whom are holding up iPhones to get a picture of their candidate. Behind them, ignored by most of the cameras, is a large empty space leading up to the rope that separates the crowds from the journalists, who number at least 150. This isn’t a passionate event. Democrats fall in love, Bill Clinton once observed..

Republicans fall in line.
Mitt Romney
Mitt Romney: insists America’s best days are still ahead

“This November, we face a defining decision,” Romney says. “Our choice will not be one of party or personality. This election will be about principle. Our economic freedom will be on the ballot.” Voters would have a choice between a constitutional law professor, who keeps apologising for America, and a businessman who for 25 years has “lived and breathed what it is that makes our American system so powerful”, Romney said. “Together, we will ensure that America’s greatest days are still ahead,” he concluded, to a chorus of cheers.

Although Obama’s programme differs sharply, he shares with his likely opponent a belief that America will prevail, as he argued in his annual State of the Union address in January. Both vigorously dispute that America is in decline. Romney, however, insists that America will start to decline if the president gets a second term. And both, in their own way, argue that it will be up to America, and America alone, whether it declines or not. “Anyone who tells you America is in decline doesn’t know what they are talking about,” Obama said in his January speech.

By the more brutal statistical measure, America’s relative economic decline is already rapidly advancing: a decade ago the US accounted for just under a third of the global economy. Today it accounts for less than a quarter. Unless the big emerging markets, notably China, India, Brazil and Indonesia, come to a halt, America’s share is likely to drop to about a sixth of the world economy by 2020. And so on. There is little the US could do to stop this.

By a different yardstick, however, the president and Romney may be right. Decline” is a subjective term. How the US responds to the deep-seated challenges it faces will determine whether it can once again be a country that is admired. Almost 200 years ago, Alexis de Tocqueville famously observed that America’s greatness lies in her ability “to repair her faults”. The French, de Tocqueville wrote, are obsessed with what works in theory, Americans with what works in practice. “America is therefore one of the countries in the world where philosophy is least studied, and where the precepts of Descartes are best applied,” he wrote.

It is no accident that it was an American, Charles Sanders Peirce, who coined the wordpragmatism” to capture this approach half a century after de Tocqueville described it. The word is distinctively American. Yet it is a quality that seems to have gone missing in actionat least in terms of how America governs itself. The US faces two core problems that intertwine like a Gordian knot. Unless that knot is cut, it is hard to see how America will renew itself.

First, the great American middle class is in long-term crisis. Most people cannot get secure, well-paid jobs any longer. The top 1 per cent captured 93 per cent of the income gains in 2010. The remaining 99 per cent were either treading water or seeing falling incomes. This includes those with an undergraduate or vocational degree, whose incomes have not budged in real terms since 2001. Only postgraduates and those with PhDs have seen income growth since then. Income mobility, once America’s greatest exception, is now wallowing at sub-European levels.

America now boasts of an unmatched plutocracy – or what one observer dubbed a “plutonomy”, given the growing role billionaires play in politics. Below them is an increasingly large floating world of the former and semi-middle class, who have lost the security their parents once had. Concern about a permanently divided America is not confined to the left, or the centre. Charles Murray, the conservative commentator, talks about a new cognitive elite” that lives inSuperZips” (the richest zip codes) far removed in sight and habit from those less fortunate.

People on all sides of the spectrum admit that America’s egalitarian creed looks increasingly hollow.America is a society that is starting to belie its promise as a land of equal opportunity in which the place you were born was not as important as the talents you were born with,” says Lawrence Katz.

Second, American politics tracks the growing divide between the elites and everyone else. The two reinforce each otherAmerica’s bifurcating economy polarises the politics and vice versa. America’s parties now behave in a Westminster parliamentary fashion in a system consciously designed to grind to a halt unless there is cross-party co-operation. To give one example, the use of the filibuster to block legislation in the Senate has risen to 70 per cent of bills in 2008 from just 8 per cent in the mid-1960s. Since then it has risen further. The result is often paralysis.

It would be wrong to put equal blame on both partiesRepublicans are far more parliamentary than the Democrats. As the veteran political observers Norm Ornstein and Thomas Mann point out in their forthcoming book, It’s Even Worse Than It Looks, America is suffering from asymmetric polarisation. “The Republican Party has become an insurgent outlierideologically extreme; scornful of compromise; unpersuaded by conventional understanding of facts, evidence, and science,” they write. “When one party moves this far from the center, it is extremely difficult to respond to the country’s most pressing challenges.”

The authors could have added that Washington’s prolonged impasse has already damaged America’s competitiveness. Last year Congress came to the brink of declaring a voluntary default on America’s sovereign debt. The US lost its AAA credit rating for the first time. A repetition cannot be ruled out after November when the “lame duckCongress will be asked to raise the debt ceiling again.

Lawmakers will also face momentous fiscal decisions on whether to extend the Bush-era tax cuts for the wealthiest as well as an automatic $1,200bn spending cut should they fail to agree on a deficit plan. A wrong turn on any one of these could plunge the US back into recession.

Beneath the fiscal high jinks, however, lies even more troubling evidence that America’s sense of pragmatism is missing. In daggers-drawn Washington, Democrats and Republicans have been able to agree only on a certain type of spending cut. The bulk are targeted at the one slice of the federal budget that qualifies as investment – “domestic non-defence discretionary spending”, which accounts for only 12 per cent of the pie. This includes research and development, infrastructure and education programmes areas that matter greatly to America’s future competitiveness. They could be described as the “tomorrowpart of the US budget. The remainder, which is mostly healthcare for retirees, pensions, defence and interest payments on past debt, might be seen as the “yesterdayportion. Yet Washington’s first instinct in the new era of austerity was to shortchange the future. There will be more to come even if Obama is re-elected.

. . .

Which brings us back to Gary and Palo Alto. The two cities may inhabit opposite ends of the spectrum, but their fates are tied to Washington. Both are victims of a politics that is “even worse than it looks”. Middle America needs a Marshall plan to adapt to an exponentially automating and integrating global economy.

Washington is in no danger of delivering. At the school level, America continues to slip in the international rankings and now comes below 20th in maths and science. In terms of higher education, it is slipping even faster. Just a generation ago, the US had the highest proportion of graduates in the world. Now it is 16th.
Facebook HQ
©Jamie Kingham
Thriving: Facebook HQ – yet fund-raising in Silicon Valley is now declining

Likewise, Palo Alto needs to be able to attract the most risk capital and the brightest entrepreneurs if it is to remain the world’s leading incubator of new innovation. Yet the pool of risk capital keeps shrinking.

Sequoia Capital, one of Silicon Valley’s largest venture capital firms, now has eight offices, of which only one is in the US. Annual fund-raising in Silicon Valley is running at less than 15 per cent of where it was in 2000 when the dotcom bubble burst.

Apple may now be worth more than any company in the world. But the future flow of ideas, and the spread of R&D, is globalising. So too is American-educated talent.

The Washington of earlier decades would have stapled green cards to foreign graduate degrees. Nowadays, having received a subsidised technical education, the world’s brightest students are put on a plane and sent back home.

Fear trumps hope. As US commentator Fareed Zakaria remarked, “Every visa officer today lives in fear that he will let in the next Mohamed Atta. As a result, he is probably keeping out the next Bill Gates.”

In contrast with what Larry Summers, the former national economic adviser, likes to call Washington’slooney tunes”, America’s market clearing process beyond the beltway remains the most efficient in the world. America has outperformed its counterparts in deleveraging since the start of this “balance sheet recession”. US households have paid off far more of their debts than Europeans. America’s performance looks impressive. But the gains may be pyrrhic. Germany has suffered far lower joblessness than the US because it has subsidised employers to keep workers on their books.

That minimises the taxpayer costs of the recession and prevents what economists callhysteresis” – the process by which workers gradually lose their skills, self-respect and ability to work. The US has done very little to keep its vast reserve army of labour in shape.

This will store up costs for the future in terms of larger prison populations, higher suicide rates and family breakdown. “I don’t worry much about the efficiency of America’s market system,” says Tim Geithner, the US Treasury secretary. “I do worry about what I call America’s dark side. We need to find better ways of fixing it.”
US manufacturing
©James P. Morse
Manufacturing: falling sharply

That may be an understatement. Far from being an afterthought, or a moral side issue, the fate of America’s labour force is its most pressing problem. Almost every elected American pays lip service to an economy of the future based on brain power. But it takes time to build a new generation of homegrown brains and the country is doing its best to deter foreign ones. Unsurprisingly, much of the action is therefore shifting with the IQs, whether that is to Singapore, Canada, Germany or China. Roughly three-quarters of US private R&D comes from manufacturing companies, which now account for barely a 10th of the US labour force. In spite of a recent shift towardsreshoring”, the trend is still eastwards.

Then there is the human dimension, which is after all what an economy is supposed to serve. At the Majestic Casino in Gary, I talked to Alicia Kimbrough, a quick-witted woman from Chicago, who makes a good living as a refinancer of student loans. Every month or so, she heads to Gary to play blackjack. Last year she reckoned she was up $5,000. “Eventually the house wins,” she says. “I know that.” Far better off than most of the patrons, Alicia talks about how the casino is sucking the life out of the community. “Most of the people here are desperate,” she says. “The casinos are just preying on them.”

It is 11am on a Wednesday morning and half the tables are busy. The age range is striking. One patron can only move with the help of a Zimmer frame while still clutching a large bag of change. Younger ones are downing beers at their games. Alicia is already down $700. “They’re the ones putting the money up,” says Alicia, gesturing at the scattering of patrons, almost all of whom are in shorts, T-shirts and baseball caps. “No one else is betting any money on them.”

Edward Luce is the FT’s chief US commentator. His book ‘Time to Start Thinking: America and the Spectre of Descent’ is published on April 3 by Grove Atlantic in the US and Little, Brown in the UK. This essay is not an excerpt.

Copyright The Financial Times Limited 2012.

All Spain All the Time
By John Mauldin
March 31, 2012

Last Monday I was in Paris and was asked to do a spot on CNBC London. I arrived at the studios an hour early due to a misunderstanding of the time zones, so while trying to catch up on the news I listened to CNBC. I had just written about Spain in last week's letter and guessed that was what they wanted to talk to me about, but for the full hour before I got on it seemed like every guest wanted to talk about Spain. When I had my turn and indeed got the Spain question, I smiled and noted that we were now in a period when it would be "All Spain All the Time," for at least the next year. I should have noted that there would be brief interruptions where we glanced at Portugal and perhaps Ireland, but the real focus would be on Spain.

I fully intended to write about something other than Europe this week, but the events of the last 24 hours compel me to once again look "across the pond" at the problems that not only plague Europe but will be a drag on world growth as well, as Europe goes through its continued painful adjustment as a consequence of trying to adopt a single currency. Since Spain is going to be on the front page for some time, it will be useful to look at some of the problems it is facing, to put it all into context. And what I heard while in Europe in private meetings is troubling.

All Spain All the Time

Spain is in a recession, though only down an estimated 1.7% in 2012, if things go well. Unemployment is at 23%, which is higher than Greece for the latest Greek data that I can find. But more than half of young Spaniards (over 51%) are out of work, creating a lost generation that has been hardest hit by Spain's economic woes. The total number of unemployed has climbed above five million, and Spanish under-25 unemployment has nearly tripled, from 18% just four years ago.

"'This is the least hopeful and best educated generation in Spain,' said Ignacio Escolar, author of the country's most popular political blog and former editor of the newspaper Publico. 'And it's like a national defeat that they have to travel abroad to find work.' Young Spaniards are now living in the family home longer than ever before, pushing the average age of independence from their parents to well into their thirties." (The Telegraph)

Unions called a general strike on Thursday as the recently elected Spanish government delivered its new austerity budget. While the protests were mostly peaceful, the pictures we see are of youth in partial riot mode. It is eerily similar to the onset of riots in Greece just a few years agoexcept that unemployment is higher than when the Greek crisis started. And while Spanish leaders will protest that Spain is not Greece, there are striking similarities.

As an aside, let's remember that Habsburg Spain defaulted on all or part of its debt 14 times between 1557 and 1696 and also succumbed to inflation due to a surfeit of New World silver. Portugal has defaulted on its national debt five times since 1800, Greece five times, Spain no less than seven times. There have been more than 250 sovereign debt defaults since 1800.

Structural versus Cyclical Dilemmas

A country (or a family) can face two different types of crises. A cyclical crisis is typically temporary and due to a business-cycle recession. When the problem that caused the recession is dealt with, the economy comes back and employment returns to normal.

Structural problems are more difficult to deal with. Structural unemployment is a more permanent level of unemployment that's caused by forces other than the business cycle. It can be the result of an underlying shift in the economy that makes it difficult for certain segments of the population to find jobs. It typically occurs when there is a mismatch between the jobs available and the skill levels of the unemployed.

Structural unemployment can result in a higher unemployment rate long after a recession is over. If ignored by policy makers, it can then even lead to a higher natural unemployment rate. Structural unemployment can be created when there are technological advances in an industry. This has happened in manufacturing, where robots have been replacing unskilled workers. These workers must now get training in computer operations to manage the robots and employ other sophisticated technology, in order to compete for fewer jobs in the same factories where they worked before. (

But structural unemployment may also be caused by government policies that make it difficult or even uneconomic for businesses to hire workers. Typically these policies are put in place by well-meaning if economically ignorant politicians (nobody wants to create unemployment), but the problems are there no matter what the intentions were. Let's look at a few Spanish structural problems.

The first is a rather poisonous employment environment. The graph below was created by The Bank Credit Analyst to discuss structural employment problems in France, but the country that is even higher on the employment protection index is Spain. Note that both countries are higher than 3rd and 4th place Greece and Portugal.

In an open market, the large majority of jobs are created by small businesses. But when you make it difficult and more expensive for small businesses to hire workers, it is not surprising that you get fewer jobs. In the US, our experience is that when the minimum wage rises, youth unemployment rises as well, even in times of recovery. This has been consistent over the last few decades, when statistics have been kept. There are a lot of reasons for this, which we will not go into today, but there is every reason to believe that Spain in particular and Europe in general would be no different in that respect from the US.


The Mother of All Housing Bubbles

Spain had its own housing bubble, in most ways worse than that of the US. In 2006, the Guardian wrote that 50% of new EU jobs had been created in Spain during the previous five years. But in 2011 housing starts were down by 94% and new mortgages by 81% (IMF, 2011). The IMF notes that "The stock of unsold units may take around another four years to clear. The lowest estimates of the stock of unsold units are at close to 700,000 units, with considerable regional variations but with a downward adjustment that has only started at the end of 2010. These only include newly completed units, and do not fully include units repossessed by financial institutions, unsold secondary market houses, or unfinished units."

The Wall Street Journal suggests the number may be more than double that:

"Some 1.5 million unfinished, unsold or unwanted residential units stand scattered across the country, products of a still-deflating housing bubble that threatens to undermine Spain's broader economy for years to come. It is the hangover after an epic fiesta, a period Spaniards now refer to as "cuando pensábamos que éramos ricos"—'when we thought we were rich.'"

Let's put that in context. The US has about 6.5 times more people than Spain. There are 2.43 million existing homes for sale plus shadow inventory in the US, estimates of which vary. Using the WSJ number, this would suggest Spain has the equivalent of 15 million-plus homes for sale. That in a country where unemployment is more than double ours and where population growth and household formation is certainly slower than in the US. Only Ireland can rival Spain for the largest housing bubble.

The number of homes being foreclosed on is estimated to triple in Spain. About 120 evictions take place every day. Those who default on their mortgages cannot walk away from the debt, as in the US. A story is out tonight about one resident who lost her job and is being foreclosed on. She will still owe over about half her debt, or more than €100,000, plus court costs and penalties. From the Huffington Post: "

If the bank manages to sell a foreclosed home, that amount is struck off the remaining debt. But the norm these days is that the property is put up for auction and nobody bids. That has meant the bank then takes over the house for just half its originally assessed value, and wipes the amount off the remaining debtleaving the borrower still owing a bundle. The legislation passed last week raises the proportion the bank has to effectively pay in the event of non-sale to 60 percent."

Home prices have fallen just 10-20%, as banks cannot afford to write down mortgages (more on that later). Realistic estimates assume a 40-50% total drop is more likely, and anecdotal evidence suggests it could be even more if the economy does not recover soon. And as we will see, that is going to be tough.


Spanish Banks en Bancarrota

I am not sure if the Spanish term for bankrupt is en bancarrota or quebrado, as Google didn't make it clear.

(Sidebar: The former sounds suspiciously Italian, as it is the term for "broken bench," which was the medieval term for what happened when a merchant bank went under. Its bench was literally broken. Our guide pointed to a spot in Sienna where she said the first banks and the term originated. And it is where the English word bankrupt comes from.)

In any event, there is widespread agreement that the regional Spanish banks, the cajas, are bankrupt, as they made massive loans for construction and mortgages. The government has taken some action, forcing 45 caja savings banks that were threatened by bankruptcy due to bad property loans to consolidate down to 14. But although bank regulators have estimated that Spanish banks will need €26 billion in extra capital, many skeptics believe this severely underestimates future losses and that the government may have to step in with a much larger bailout for the financial sector. The Bank of Spain contends that construction debt to banks stands at some €400 billion, of which repayment of €176 billion is questionable, with €31.6 billion of those considered nonperforming. (WSJ)

Spanish private debt is 220% of GDP, dwarfing government debt, which is high and rising. So not only are banks being forced to raise capital and reduce their loan books, consumers and businesses are also overextended. The government wants to increase taxes or reduce spending by 17% to get the deficit down from over 8% to 5.5%, a combination that is not geared for growth.

€12.3bn will be raised in new taxes, with €5.3bn coming from corporations, and €2.5bn is projected to come from a temporary amnesty on tax evasion (you've got to love the optimism). We have seen how such policies worked in Greece. They meant lower, not increased, revenues. Note that Britain also raised taxes on "the rich" and saw revenues fall in that category, not increase as projected.

Further, as we go along this year, watch for "breaking" news that off-balance-sheet guarantees by the Spanish government will be huge, adding multiples of 10% to total debt-to-GDP. Spain's admitted government debt is over 70% of GDP, which in comparison to other European countries is not all that bad. Except that is not the extent of the problem. There is regional debt, bank-guaranteed debt, sovereign guarantees, etc. that take it to roughly 85%.

And then we add the guarantees that Spain has made to the EU for all the stabilization funds, ECB liabilities, etc., at which point Mark Grant suggests that Spanish debt may be closer to 130% of GDP. (Of course, if we count all debt and guarantees, something that a normal bank would make you or me do if we wanted a loan [at least since the subprime debacle], then Italy has over 200% debt-to-GDP. Just saying.)

Spain is going to have an uphill struggle to keep its deficit down to 5.5%. Unemployment is still rising, as Spain is after all in a recession and costs will be up and revenues down. But the current budget buys time and what will amount to good will from the rest of Europe, as Spain will be seen to be trying, conducting yet another experiment in austerity. When those deficits come in higher, then what will Europe do? With each piece of bad news, the problem of funding Spanish debt will grow. Right now, Spanish banks are buying Spanish government debt with everything they can muster, which is to say, ECB loans at 1% for three years, invested in 5.5% bonds. With 30 times leverage. All the while trying to cut losses and reduce their loan books – a trick worthy of Houdini.

Meanwhile in the Rest of Europe

Let's quickly take a turn around Europe. Germany is preparing to reduce its budget, which will reduce inflation and also relative labor costs, which will make it more difficult for peripheral Europe to catch up on their massive trade deficits. In a story tonight in the Telegraph, with the headline "Germany launches strategy to counter ECB largesse," Ambrose Evans-Pritchard notes that "The plans have major implications for monetary union, dashing hopes in Southern Europe that Germany might accept a few years of mini-boom at home to help lift the whole system off the reefs.... 'The Bundesbank does not want to be blamed for making the same mistakes as central banks in Ireland and Spain where they did not address asset bubbles early enough,' said Bernhard Speyer from Deutsche Bank.... The German authorities are in effect preparing a form of quasi-monetary tightening to offset ECB largesse."

I keep noting that the third leg of the euro crisis, the trade imbalance between northern and Southern Europe, must be addressed or there is no real solution, just short-term Band-Aids. Ambrose's column goes on to note that Germany is hoping the rest of the world will do their job to provide a positive trade balance for peripheral Europe, all the while continuing its own massive surpluses. Unless and until the peripheral countries adopt their own currencies, the adjustment will be slow and painful, and the countries will be in recession for years, until wage costs (income to workers) drop by 30% relative to Germany. That is the ugly reality.

Wolfgang Munchau, writing in the Financial Times, notes that even with the proposed increases in the European bailouts funds (the sources and variety of which are quite confusing, so let's look at them in the aggregate) there is not going to be enough for Spain:

"The current ESM is big enough to handle small countries, but not Spain. I expect Madrid eventually to apply for a programme, specifically to deal with the debt overhang of the Spanish financial sector. But even a minimally enlarged version of the ESM will not be big enough.

"What this stand-off tells us is that we are approaching the political limits of multilateral programmes. If you want to claim funds of such size, you need joint and several liability – ie all eurozone countries need to be jointly liablenot individual liability among member states. Call it a eurobond, call it what you like. If you do not want that either, then you have to accept that there is simply no backstop for Spain. As I said, welcome back to the crisis."

And Two More Leaked Documents

And also tonight, we get two leaked documents from today's meeting of the European finance ministers. (I am not certain why they keep trying to keep these documents secret, as the press typically gets them before the ministers do.)

The first document tells us that €1 trillion in ECB largesse is not enough and has simply calmed the storm. "Contagion may ... re-emerge at very short notice, as demonstrated only a few days ago, and re-launch the potentially perverse triangle between sovereign, bank funding risk and growth," one of the analyses, prepared by the EU's economic and finance committee and seen by the Financial Times, said.

From the Financial Times:

"The second document, which was prepared by the Commission, warned bluntly: 'The euro crisis is not over. Many of the underlying imbalances and weaknesses of the economies, banking sectors or sovereign borrowers remain to be addressed.' "

The paper argued the elements of the recent restoration of confidencefinalising a second Greek bailout, increasing the eurozone's rescue fund, EU-wide bank recapitalisation, new eurozone fiscal discipline rules, and efforts to pass policies to encourage growthmust be fully implemented or leaders risk losing their last chance to act.

"'If this window of opportunity is not most effectively used ... we might have missed the last chance for a considerable amount of time,' the analysis said."

The Fat Lady Has Not Sung

As I wrote last week, I was at the Global Interdependence Center conference on central banking in Paris. It was the coming out of the GIC Global Society of Fellows, ably headed up by my friend Paul McCulley, formerly of PIMCO. David Kotok, who runs Cumberland Advisors (and who runs the annual August fishing trip in Maine) is the GIC vice-chair. He wrote a short note of his take-aways, and I found it striking and worth a few minutes of your time, as a few years ago he wrote a very bullish book on Europe. His candor, given that former view, is sobering. The rest of the letter is his:

Back from Paris

David Kotok

We are back from Paris. The head is filled with new info. For the publicly available portion of the conference, see the GIC website, The remaining comments will be my personal "takeaways" from both public and private conversations. By Chatham House Rule and Jackson Hole Rule, these words are attributable only to me. All errors are mine.

1. In my view, the situation in Portugal is unraveling. This may be the second shoe to drop in the European sovereign debt saga. Now that Greece has paved the way, the speed of unwind with Portugal may be much faster. I do not believe the markets are prepared for that. Runs are affecting Portuguese banks. Euro deposits are shifting to other, safer countries and the banks that are in those countries. Germany (German banks) is the largest recipient. Remember, deposits in European banks are guaranteed by the national central banks and the national governments, not the ECB. There is no FDIC to insure deposits in the Eurozone.

2. The issue is that Greece was supposed to be "ring-fenced." Notice how European leaders have stopped using that word. Their new word is firewall. If a second country (Portugal) restructures, the sovereign debt issues become systemic rather than idiosyncratic. That becomes the second game-changer. Systemic risk needs big firewalls. We learned that the hard way with Lehman and AIG, which were systemic, vs. Countrywide and Bear Stearns, which were "ring-fenced" – or thought to be ring-fenced at the time.

3. A game-changer was the use (not threat) of the collective action clause by Greece. CAC altered the positions of the private sector. It rewrote a contract after the fact. That is why Portugal's credit spreads are wide: the private-sector holders of Portuguese debt know that a CAC can be used on them, too. The same is true for all European sovereign debt. A re-pricing of this CAC risk is underway.

4. Private holders of Greek debt had several years to get out before the eventual failure. Those that did not get out were crushed in the settlement. Greece is now a ward of governmental and global institutions like the ECB, IMF, and others. It is unlikely to have market access for years. This is another game-changer. In the old crisis days, the strategy was to regain market access quickly and restore private-sector involvement. In the new Eurozone-CAC crisis days, the concept is to crush the private-sector holders, and that means no market access for a long time. Instead, we will have ongoing and increasing sunk costs by governmental institutions. Caveat: government does not know how to cut losses and run. Government only knows how to run up small losses until they are huge. Witness Fannie Mae in the US. Witness the sequence that allowed Greece to fester for years. Government does not know how to take the "first loss," which is usually the smallest lost. Government does know how to run up moral hazard.

5. The term moral hazard means the action is done today and the price is determined later, after the chickens come home to roost and crap all over the coop. That is the nature of government everywhere. By the time the chickens return, the political leaders have changed. Those who took the moral hazard risk are gone. Those who inherited their mess are blamed during the cleanup. That is where we are today in Europe. Hence, the political risk is rising daily. Elections could change these governments, and the new governments may repudiate the actions of the old ones. We expect more strikes and unrest. That is how elections can be influenced.

6. European debt-crisis issues are lessons for the US. They belong in the political debate. Both political parties are responsible for our growing debt issues. Bush ran up huge deficits. Obama continued them. Each party blames the other. Neither takes on the responsibility of their actions. We shall see how this evolves between now and November. I am more pessimistic about peripheral Europe than I have been. All that my co-author Vincenzo Sciarretta and I wrote in our book several years ago is now being reversed by policies. In the beginning, the Eurozone benefited immensely from economic integration and interest-rate convergence. Now it faces disintegration and divergence. Reverse the chapters in the book and play the film backwards. Can Europe find a stabilizing level and resume growth? Time will tell. Meanwhile, political leaders and central bankers are going to be tested again.

This ain't over. Yogi is correct.

It is time to hit the send button. Have a great week and make sure you see some old friends who mean a lot.

Your fading fast, too far past midnight analyst,

John Mauldin

Copyright 2012 John Mauldin. All Rights Reserved.