Chief Medical Officer Liam Donaldson has recommended that the government should sharply raise the price of alcohol  to try to combat Britain's chronic drinking problem.

His annual report calls for a minimum price of 50 pence per unit of alcohol sold, which would nearly double the price of some discount beer and wine. Scotland, Wales and Northern Ireland have also shown interest in minimum pricing.

But the government is under no obligation to accept any such recommendation and is aware of the unpopularity of raising alcohol prices in a recession and not so far away from a general election.

Gordon Brown rejected the proposal outright.

The Conservatives say it is important to deal with people's attitudes to drinking, not just supply and price, while the Liberal Democrats support putting an end to "pocket-money priced" alcohol.

What do you think? Does price play much of a part in Britain's binge-drinking culture?

-- James Saft is a Reuters columnist. The opinions expressed are his own --

The U.S. policy of keeping zombie financial institutions alive is so clearly failing that it is now attracting attack from inside policymakers' circle of covered wagons.

The most interesting intervention in the banking debate in the past few weeks was an extraordinary attack by Kansas City Federal Reserve President Thomas Hoenig on what he termed a policy of "piecemeal" nationalization which leaves discredited management in place, repels new capital from the banking system and allows bad assets to fester rather than be cleared.

This is no academic who can be dismissed as having a poor grasp of the major systemic consequences of letting the big zombies fall, this is the man who has been a Fed president for 17 years and has a deep history in banking regulation, deeper and with more practical experience arguably than the people making the policies in Washington.

"If an institution's management has failed the test of the marketplace, these mangers should be replaced. They should not be given public funds and then micro-managed, as we are now doing under TARP, with a set of political strings attached," Hoenig said.

In short, it's not an ideological attack on runaway market forces but a collection of sensible practical considerations that should limit the ideologically based decisions now being made.

And be in no doubt; administration policy as laid out by Treasury Secretary Tim Geithner, Fed chief Ben Bernanke and White House economic advisor Larry Summers has as its core a fervent commitment not to take into state control large insolvent institutions, preferring instead to essentially bear the risk and the cost without having a clear line of accountability for day-to-day bank actions.

They are in essence going down the route Japan took in the 1990s, keeping banks alive and hoping they will earn their way out of the capitalization hole. And, to be fair, the yield curve in the U.S. is a lot steeper than it was in Japan, meaning that banks will earn on the difference between their funding costs and the longer-term rates they charge customers.

But there is are quite a lot of opportunity costs built into that strategy, even if it is convenient in avoiding temporary public ownership of large parts of the banking system.

These costs may only make themselves apparent in retrospect, if we find ourselves in two years time with a struggling banking system that still can't intermediate capital effectively. More likely those costs will become uncomfortably visible in only months. Despite protestations from Citigroup and others that they are producing profits, there is a real danger that the unpredictable and ad hoc way in which banking is being bailed out scares depositors and, more to the point, bond buyers and clients into withdrawing their money, business and credit from ailing banks.

That's how this will play out, not by the U.S. administration suddenly going all five year plan on us, but being forced to step in by events caused partly by their own inability to inspire confidence.

A GREAT TIME TO BE A BANK, PITY ABOUT THE COMPETITION

That is the sad irony, in many ways it's now a pretty good time to be a bank, only you want to be one without legacy assets. Somebody should be making fat margins, what with there being less competition and a steep yield curve.

But why on earth would you commit funds to the banking system when you have no credible view on how capital will be treated by government going forward. I'd be scared witless that my equity ends up being forced into making all sorts of lousy loans for political purposes, or that as a bondholder I am ultimately forced to take equity when the losses become too big for even government, or that I face competition from some zombie with government funding and non-economic marching orders.

None of these are avoidable problems. But what we could do is deal with them quickly, share out the pain transparently and move on. And just because some of the insolvent institutions are huge doesn't mean they can't be handled. As it stands the incentives for banks are to be too big to fail, and to be "independent" but pliable.

Hoenig points out that the Depression-era Reconstruction Finance Corporation at one point held capital in 40 percent of all U.S. banks but because it was aggressive in writing down assets to realistic levels and turfing out failed management was able to do it without any net cost to government or taxpayers.

But for that to happen we have to write down assets to their clearing price, not prop them up so that we can pretend we all still live in 2006. If you do that, banks and the economy have a chance, capital will return, loans will be made where they make sense and growth eventually will return.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. --

James H. Carr is chief operating officer for the National Community Reinvestment Coalition, a Washington-based association that promote access to basic banking services for America’s working families. He is a member of the Insight Center for Community Economic Development’s “Experts of Color Clearinghouse”. The views expressed are his own.

The U.S. economy is unraveling at a pace not seen in decades. The more than 650,000 jobs lost last month has contributed to a growing concern that the unemployment rate could rise to 10 percent or higher before the economy rebounds. At the center of the economy’s instability is a foreclosure crisis that has claimed 3.5 million homes in the last year alone, and threatens the loss of an additional 8 to 10 million homes to foreclosure over the next five years.

The loss of wealth associated with the collapse of the housing market is staggering. More than $5 trillion in housing equity has virtually evaporated since the foreclosure crisis began. Major stock indexes have also been cut in half, further contributing to decreased consumer confidence, substantially reduced spending, lower productivity, rising unemployment and additional foreclosures.

The magnitude of the economic decline has led many observers to conclude that the current crisis is an “equal opportunity financial nightmare.” But, reality paints a different picture.

While few have been able to escape the financial pain completely, African Americans, Latinos, Native Americans and many Asian sub‐populations are bearing the brunt of this national epidemic. Today, as the national unemployment rate rests at 8.1 percent, African Americans and Latinos are mired in double-digit job losses -- the unemployment rate exceeds 13 percent for African Americans, is just under 11 percent for Latinos, and is a little over 7 percent for non-Hispanic whites. For young black males, the rate is 25 percent and climbing.

Before the current crisis, African Americans and Latinos held on average a mere $10 and $12 of net worth respectively for every $100 held by the typical non‐Hispanic white household. The disproportionate impact of the foreclosure crisis on African Americans and Latinos expands further the racial and ethnic wealth gap.

African Americans and Latinos were the disproportionate targets for the unfair, deceptive and reckless lending practices that triggered the foreclosure collapse and imploded the credit markets. The situation is so dire within the African‐American community that United for a Fair Economy, a Boston‐based policy group, estimates that African Americans could experience the greatest loss of wealth since Reconstruction.

To date, federal intervention has focused almost exclusively on propping up the credit markets. While ensuring the health of the credit system is essential, ignoring the plight of struggling homeowners has proven to be a costly and ineffective remedy. In total, the federal government has provided $9.7 trillion in investments and loans to ailing financial institutions. This amount is equivalent to almost 90 percent of all mortgage debt outstanding. Yet only 11 percent of outstanding home loans are delinquent or in foreclosure.

Meanwhile, the financial system remains in critical condition and may require several hundred billion dollars of additional life support. The Obama administration recently launched the most comprehensive program to date to stem foreclosures, but more borrower‐focused assistance is needed. The administration has also enacted a major economic recovery program to preserve or create 3 to 4 million jobs. Although impressive in scale and scope, that nearly $800 billion package of stimulus spending will not fully repair the severely damaged economy that has been inherited by the new administration.

There is growing consensus that a second round of stimulus will be needed. The administration and Congress should consider targeting spending in a manner that prioritizes communities that have the highest levels of unemployment, the greatest concentrations of foreclosures and historically under‐funded, inferior or poorly maintained infrastructure.

Channeling dollars to individuals and communities that need them most will immediately stimulate the economy and save and create jobs because families living on the margins of survival will pour those recovery dollars immediately back into the economy through spending on food, medicine, clothing, child care, energy, transportation and other necessities. Prioritizing areas hardest hit by the foreclosure crisis would more directly help stabilize the housing markets and steady falling home prices that continue to infect financial institutions.

Finally, investing in areas most in need of infrastructure improvements would provide fertile ground for shovel‐ready projects in communities long‐neglected. This prioritization of economic recovery spending would not only jump start the economy, it would aid the most financially vulnerable populations, stabilize communities, and reward all Americans by providing a more direct route to economic recovery.

Of course, there are those who will feel now is not the time to focus on wealth and income disparities and that further one‐time tax rebates to struggling middle-income families generally would be more equitable in the current crisis. But broad‐based stimulus checks will not have the same economic leverage effect as channeling those same dollars to the families and communities that need them the most.

—James Saft is a Reuters columnist. The opinions expressed are his own. –

By all means reform accounting, but for pity's sake take your time and keep your expectations low.

Suspending mark-to-market accounting immediately as a means of levitating banks out of peril simply won't work. While transparency may or may not be the foundation of banking, trust undoubtedly is.

"Adjusting" or suspending fair value accounting, even if you swear up and down that this time it's even more fair will erode rather than build trust and repel rather than attract capital.

The House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, led by Congressman Paul Kanjorski of Pennsylvania today is holding a hearing on mark-to-market and already the industry knives are out.

A group of 31 industry groups and financial institutions, including the American Bankers Association, Mortgage Bankers Association and U.S. Chamber of Commerce, have petitioned the committee to take "immediate action" to stop the "spiral of accounting-driven financial losses," according to the Los Angeles Times.

They argue that current rules, which force banks to carry some securities on their books at levels that reflect current market prices, mean they have to recognize losses that "do not have a basis in economic reality".

That's as may be, but so far market prices have arguably been a better directional indicator of the future performance of collateral than some hopeful internally generated marks. Is mark-to-market perfect? No. Might reform, in the fullness of time, adjust some of its pro-cyclical effects? Yes. Will doing that in the midst of a crisis have the desired effect? No.

This whole effort fundamentally misunderstands the situation facing banking.

The problem facing the banking industry is not just solvency on some accounting or regulatory basis, it is solvency on, for want of a better phrase, a solvency basis. Thus banks are unwilling to do business with one another and investors unwilling to lend banks money or invest in them. They do not reliably know who is bust and who is not.

Some may possibly be tarred unfairly by mark-to-market, but allowing everyone to step back from market discipline will make investors less willing to commit capital to banks and banks less willing to do business with one another.

Regulators and accountants may turn a blind eye, but given the current set of economic circumstances people with money on the line won't find internally generated prices for assets more inspiring of confidence than market derived ones. Quite the opposite.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

– Jeff Bussgang is a General Partner at Flybridge Capital Partners, an early-stage venture capital firm in Boston. This post originally appeared in the Vox Populi section of www.peHUB.com. The views expressed are his own. –

When I was a kid, I was obsessed with the newly invented personal computer. In 1982, I used my paper route and Bar Mitzvah money to purchase an Apple II+ PC (my parents did subsidize the purchase somewhat, I confess). I was mesmerized by the magic of the personal computer and all its possibilities: games, programming, communications and more.

But what I really fell in love with was this new, magical thing called the reset button. Don’t like where you find yourself in the middle of Space Invaders? Hit the reset button. Frozen out in the midst of trying to log on to a bulletin board? Hit the reset button. Mad at your older sister for messing with your top score in Asteroids? Hit the reset button. This magical button represented a unique opportunity to erase the past and begin anew with a clean slate.

Twenty-seven years later, the theme of hitting the reset button has come back in spades. Moody’s Economy.com projects 15 million homeowners are underwater – that is, their homes are worth less than what they owe on their mortgages. President Obama’s latest piece of legislation in front of Congress is aimed at allowing these homeowners to hit the reset button with their lenders. Similar debt work outs are happening across corporations.

Throughout VC-backed portfolios (i.e., small companies) and large companies, CEOs and CFOs are in discussions with lenders to renegotiate their debt and attempt to hit the reset button on a new set of terms in light of the current economic turmoil. In foreign affairs, a similar tone is being struck. A few weeks ago, Vice President Joe Biden declared it was “time to hit the reset button” in Washington’s relationship with Russia and Iran, among others.

Will these efforts work? On the economic front, there are pernicious, cascading effects to these “resets”. A rather depressing but insightful recent Merrill Lynch report, titled “Some Inconvenient Truths”, suggests there is $6 trillion in private sector (household and corporate) debt that needs to be eliminated before we can embark on a fresh credit cycle. To date, there has been “only” $1 trillion in write downs. The implication? We are nowhere close to hitting bottom, and hitting the reset button is a necessary but painful part of the process.

That’s the macro picture. At the micro level, I am seeing people hitting the reset button all over the place as well. For many, the wealth trajectory they thought they were on is no longer the case. The expectations they may have had for themselves or their children are being re-examined. Many are sitting down and revisiting all the assumptions they had made a year ago about their assets, retirement and job security. My portfolio companies are all questioning their old assumptions and making tough choices about how much to invest ahead of revenue, and how many products and markets they can pursue in parallel.

But my rabbi made an interesting point to me this weekend. He pointed out that there is a silver lining in hitting the rest button. Rather than simply wallow in the bad news, people can view hitting the reset button as an opportunity, rather than a burden. It allows them to let go of unrealistic expectations and focus on reality in a new way. It allows them to reset priorities, zoning in on what really matters to them and eliminating distractions. An economist’s view of this sage rabbinical advice would be to observe that when your opportunity cost to pursue alternative paths has plummeted around you, anything is possible.

As a result of the opportunity for deep personal growth and new direction, hitting the reset button all around the world should mean more entrepreneurship everywhere. This trend appears to be playing out. I met with the co-head of Harvard’s Entrepreneurship Forum last week and she couldn’t have been more excited to tell me about the burgeoning entrepreneurial culture that’s emerged at Harvard.

“The current economic environment has freed people up to do what they really want to do,” she observed, “not just follow a certain path that they think they ought to follow.” She reports that submissions to Harvard’s business plan competition are double this year as compared to last year. Similarly, participation at the MIT $100k competition was stronger than ever.

Many economists are pointing to the parallels between our current recession and that of the one in 1982. That was the year I learned the magic benefits of the reset button. Hopefully others will as well.

-- Bernd Debusmann is a Reuters columnist. The opinions expressed are his own. --

It's no longer in print but you can get it over the Internet and $1.99 (plus shipping and handling) buys you a well-preserved copy of Dow 36,000, a book that has become an emblem for really, really wrong forecasts.

With the Dow Jones Industrial Average below 7,000 and the U.S. in its worst financial crisis in 80 years, re-reading the book is a bizarre experience, as well as a lesson that being wrong does not necessarily harm the prognosticator's career.

On the contrary. Many have flourished, from the perpetually upbeat hosts of financial cable television shows to authors of "how to become a millionaire" advice.

Take James Glassman and Kevin Hassett, authors of "Dow 36,000, The New Strategy For Profiting From the Coming Rise in the Stock Market". It was published ten years ago, made bestseller lists and catapulted Glassman, a financial columnist, to celebrity status and a series of high-profile jobs, including undersecretary of state for public diplomacy in the last 11 months of George W. Bush's presidency.

Hassett, a scholar at the conservative American Enterprise Institute, a Washington think-tank, largely stayed out of the limelight but John McCain valued his expertise so highly that he made him senior economic advisor for his unsuccessful 2008 presidential campaign.

"A sensible target date for Dow 36,000 is early 2005," the two said in their book, "but it could be reached much earlier.

After that, stocks will continue to rise, but at a slower pace." If the history of earnings growth repeated itself, they ventured, "Dow 36,000 itself will be a distant memory - of happier times when stocks were still cheap."

This week, in an interview with the Washington Post, for which he used to write a column, Glassman described as sound the history and logic (stocks perform well in the long run) on which the book were based and wondered "Are we in a period so different that we can no longer take our view from history?"

Tricky question. Despite routine comparisons between the Great Depression of the 1930s, there's no precedent for today's crisis. And identifying turning points in history has defied eminent historians.

Remember "The End of History", the famous essay Francis Fukuyama wrote after the fall of the Berlin Wall in 1989? Mankind's ideological evolution had ended, he argued, to be replaced by the "universalization of Western liberal democracy as the final form of human government."

FROM OPTIMISM TO DESPAIR

That has yet to happen, if ever it will, in places as far apart as Congo and Darfur, Egypt and Saudi Arabia, Russia and China.

The most memorably wrong financial predictions have tended to be on the exuberantly optimistic side. Irving Fisher, an economics professor at Yale, earned a place in the history books with a speech, on October 14, 1929, in which he said "stocks have reached a permanently high plateau." The worst stock market crash in history came two weeks later.

Now, after years during which prophets of financial nirvana commanded most attention, dominating TV ratings and bestseller charts, it is the turn of the doomsayers, a development reflected by the titles displayed at popular bookstores.

Meltdown, says one. The Return of Depression Economics, says another. It sits next to The Great Depression Ahead.

One of the most dire predictions has come from Niall Ferguson, the prolific author and Harvard economic historian who thinks that the contagion that spread from the United States to the rest of the world will have an impact that goes far beyond finance and the economy.

"There will be blood," he told a Canadian interviewer in February, "in the sense that a crisis of this magnitude is bound to increase political as well as economic (conflict). It is bound to destabilize some countries. It will cause civil wars to break out that have been dormant. It will topple governments that were moderate and bring in governments that are extreme."

Out on an apocalyptic limb? Ferguson has heavy-weight company. Dennis Blair, the Director of U.S. National Intelligence told a Senate intelligence committee that the global economic crisis presented a greater threat to American national security than anything else (terrorism included).

"The longer it takes for the recovery to begin, the greater the likelihood of serious damage to U.S. strategic interests."

A bleak view on the speed of the recovery came this week from the head of the International Monetary Fund (IMF), Dominique Strauss-Kahn. He told Reuters correspondent Lesley Wroughton in Dar Es Salaam that the advanced economies of the world were moving too slowly to rid banks of problem assets, one of the many interlocked elements of the current crisis.

How will it all end? One can only hope that things turn out better than they did for Irving Fisher, the pre-1929 crash optimist. At the time he made his "permanently high plateau" forecast, his assets totalled around $100 million in today's dollars. When he died, in 1947, he owned around $60,000.

You can contact the author at Debusmann@Reuters.com.

-- Wei Gu is a Reuters columnist. The opinions expressed are her own. --

Beijing may criticize American consumers for spending money they do not have, but the truth is Chinese leaders do the same, they just make sure it doesn't end up on their account.

In its $585 billion economic stimulus package, the central government is contributing just a quarter of the funds needed, leaving the rest of the tab to banks, local governments and the private sector.

By comparison, the U.S. Treasury is expected to fund all of America's $787 billion economic recovery plan by incurring more debt through the issuance of Treasury bills.

But just like in the West, there's no such thing as a free lunch.

The Chinese central government might have successfully transferred most of the risks and financing costs to banks and local governments from its own balance sheet, but if bad debt piles up the chickens will still come home to roost in Beijing.

China and the United States leverage themselves in different ways. America uses government credit to raise money directly from the market. China uses quasi-government financing, so that the real costs of the plan -- though indirectly ultimately a cost to Beijing -- are impossible for investors to gauge.

Beijing will have no trouble finding local governments and banks eager to help finance the stimulus plan for two reasons: it's in their political interest to please the central authority, and with liquidity abundant, they are eager to lend and projects in the stimulus plan at least have government backing.
Indeed, a record for new yuan lending in January shows banks have already responded to Beijing's call to support stimulus efforts. But there is a serious downside to the Chinese model.

"The main problem with relying on banks rather than incurring a larger explicit budget deficit is one of transparency," said Tao Wang, head of China economic research at UBS. "Relying on bank financing makes it less transparent how much spending takes place in relation to various stimulus projects."

China's budget deficit is expected to swell only modestly due to spending associated with its economic recovery plan, to 3 percent from 0.6 percent last year. In contrast, the U.S. federal deficit will shoot up to 12.3 percent this year from 3.2 percent.

WHY IS BEIJING SO KEEN?

Many economists say they do not understand why Beijing is so keen to keep the financing off its books. The state's balance sheet is probably the strongest in the world and they have no qualms about using state power to drive economic growth.

Some Chinese economists think the government is trying to avoid the scrutiny of the National People's Congress. But the NPC has traditionally behaved as a rubber stamp parliament and there is little reason to believe that would change now.

Hongbin Qu, HSBC's China economist, reckons that it just comes down to the Chinese way of doing things. He cited the way Beijing handled the costs of last year's Sichuan earthquake as an example -- the central government called upon 21 richer provinces to each partner with a heavily hit county to take responsibility for the rebuilding efforts.

"The Chinese government is used to buying a meal and getting someone else to pay," Qu said. "The central government really should dole out more money because public service is its responsibility."

Beijing has used smoke and mirrors to maximize government spending in the past. The previous administration issued government debt of $746 billion to fund almost $3 trillion worth of projects to pull China out of the Asian financial crisis -- again ultimately spending four times what it put in.

Beijing has asked banks to issue low-interest "policy loans" of more than 10 years to local government entities for stimulus-related infrastructure projects. With very little down payment for the loan required, the banks have no buffer built in for potential downsides. Moreover, investors will not know how much those potentially problematic loans are, as it will just be part of the overall bank lending.

If this approach is pursued heavily, it could eventually put at risk banks' balance sheets, their reputations and investor confidence. But again, because the projects are ultimately backed by the central government, the banks are only too happy to lend.

Also worth watching will be debt issued by local government investment vehicles. Local governments are not only expected to contribute to the 4 trillion yuan stimulus package, they have also pledged 18 trillion yuan to supplement the national plan.

But local governments don't have the money and are not legally allowed to run deficits or borrow. They get around this restriction by setting up vehicles that package their debt like company debt, which is expected to flood the market this year.

Many of these vehicles generate little profit on the operating level and the debt is guaranteed by equally weak companies, but they still get triple A ratings because of the implicit guarantee by the government.

"On the surface the government has little financial burden but the reality is it just put risks at another place," said Vincent Chan, head of China research at Credit Suisse.

-- At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund. --

-- Jonas Minton is Water Policy Advisor for the Planning and Conservation League, an environmental advocacy organization.  Previously he was deputy director of the California Department of Water Resources. The views expressed are his own. --

In many ways, water policy in the Western United States mirrors the economic policies which created our financial catastrophe. Here in the West we’ve seen a massive development boom fueled by unrealistic expectations of ever-increasing supply.

Water contracts have been issued for many times the amount of water that nature can reliably provide. Wildly optimistic appraisals of water availability are being used to justify long-term, otherwise infeasible projects. Long held cautionary principles are being overlooked or eliminated in the rush to fulfill promises and support dreams that are unsustainable. And the public is being actively encouraged to invest billions more in bonds to subsidize the very system that is driving us to the crisis point.

The result has been escalating conflict, unwieldy demands, environmental collapse and economic disaster. Fortunately, as with the economy, adjustments in expectations, greater efficiency, and implementation of new, smarter ways of doing business can reverse some of the damage we have done, allow the West to come to grips with water limits, and provide reliable water to meet our needs.

The West supported lush post World War II growth in California, Nevada and Arizona by depleting local rivers and creeks and overdrafting groundwater. As these resources dried up, cities reached out with ever deeper wells and with hundreds of miles of aqueducts to grab “surplus” water from areas with less political clout.

But just like Wall Street’s derivatives, underlying water assets were counted many times over.  In startling testimony late last year the California State Water Resources Control Board revealed that they had issued water rights permits for over 8 times the amount of natural water available in an average year. On the Colorado River, seven states cling to unreasonable expectations that they will receive the full allocation promised to them in decades old agreements. (For background information, click here for PDF.)

Over allocation is not limited to surface water. Over pumping of groundwater water is also common in the regions overlying the huge Ogallala aquifer, a major source of water supply for South Dakota, Nebraska, Wyoming, Colorado, Kansas, Oklahoma, New Mexico, and Texas.

At the same time collapsing fisheries in the Sacramento - San Joaquin Delta, caused in large part by the overexploitation of rivers put the fishing industry as well as the fish, on the brink of extinction. The crisis is so bad that the salmon fisheries on the West Coast will be closed for the second year in a row.  Court decisions to prevent loss of multiple California fish control some water projects.

Similar to what happened with the start of the Wall Street collapse; water insiders are encouraging the public to increase investments in business as usual.  Some in California are admitting to supporting more plumbing specifically to allow increased water diversions from the Sacramento – San Joaquin Bay Delta Estuary, the largest estuary on the West Coast and the epicenter of the fisheries’ collapse.

Others are pushing for energy and greenhouse gas intensive desalination of ocean water, despite known impacts to ocean fisheries.  And a few others are trying to get the public to pay billions for more dams, even though there is not enough water to regularly fill the dams that already exist.

Yet, there are emerging solutions to ease these conflicts. Cost effective, climate resilient water development such as water recycling, conservation, groundwater recovery and protection, and stormwater capture all provide opportunities to increase our water reliability while also creating quality jobs.  Policy makers are beginning to see the value of these solutions.

This year State Senator Pavley from Santa Monica is authoring Senate Bill 565 that would pave the way to create at least 2 million acre-feet of new water by 2030 through safe recycled water.  That would be the largest water development program in California since the 1960s.

Another example of smarter water management is AB 1408 authored by California Assembly member Krekorian. This measure establishes a mechanism to allow new housing to be water neutral.  Under the bill, developments would incorporate state-of-the art conservation. The bill further encourages developers to work with water districts to offset all of the demand of the development through conservation in the existing buildings. If implemented, this measure would allow California to accommodate much or our future growth without increasing water demand.

Lastly the public is just beginning to see how the institutions that were supposed to protect them need to be reformed.  Entrenched special interests dominated the decision making in the past.  State and federal water officials for too long ignored their responsibilities to ensure water sustainability and stewardship rather than extraction and exploitation.

Climate change, environmental crisis in the largest estuary on the West coast, and fiscal realities are forcing us to come to grips with limits. Fortunately, we have tools that can allow California and the West to prosper in a sustainable way, but only if we are willing to change our ways.

(For additional information, click here for the Delta Vision Blue Ribbon Task Force Report, from December 2008, in PDF format.)

-- John Kemp is a Reuters columnist. The views expressed are his own --

Even after its recent decline, the U.S. equity market does not look especially "cheap" or "undervalued" when viewed over time; the bear market has simply brought valuations back into line with long-term trends.

At a fundamental level, equity is a claim on a corporation's residual cash flow after wages, interest, taxes and other costs have been paid.

In aggregate, the total value of equity outstanding cannot grow faster than nominal GDP (which is simply the economy-wide sum of cash flows). Otherwise, corporations and their owners would need to capture an ever-increasing share of national income at the expense of everyone else.

For four decades between 1952 and 1992 this stable relationship between equity valuation and nominal GDP did indeed seem to hold in the United States.

Click here for PDF

The chartbook shows how U.S. GDP, as well as profits, debt, interest rates and the market value of equity capital evolved between 1952 and September 2008 (the latest date for which full data is available).

Between 1952 and 1992, the value of outstanding equity rose at much the same rate (8.5 percent per year) as nominal GDP (7.5 percent).

But from 1992 onwards, the relationship broke spectacularly. The market value of equity has risen almost twice as fast (9.5 percent per year) as nominal GDP (5.4 percent) (Chart 1).

As a result, the value of outstanding equity, which had been stable for four decades at 40-80 percent of GDP, doubled to 160 percent of GDP at its peak in Q1 2000 (the height of the millenarian boom). It has remained above 100 percent of GDP for most of the current decade (Chart 2).

THREE FACTORS

Rising equity valuations relative to nominal income were underpinned by three factors:

(1) Profits began to rise as a percentage of GDP from the early 1990s onwards as corporations succeeded in retaining more of the value of output in the form of surplus/profits and reduced the amount captured by employees (wages), government (taxes) and other investors (interest payments on debt). Between 1992 and 2006, the share of corporate profits in national income increased from 7 percent to 13 percent (Chart 3).

(2) In an increasingly integrated world, U.S. corporations derived a growing share of profits from operations and subsidiaries abroad. Profits overseas are tied to GDP growth in foreign countries rather than the United States. Since developing countries have grown faster than the United States over this period, the foreign component of corporate profits could (and did) increase faster than domestic profits or U.S. GDP. As a result, the proportion of foreign profits in total earnings has risen from 16 percent to 26 percent (Chart 4).

(3) Because equities are a claim on profits in future as well as the present, valuations are sensitive to the discount rate used to convert future profits back into current values. By lowering the discount rate, the steady fall in long-term U.S. interest rates between 1982 and 2007 as part of the "Great Moderation" made these future profits much more valuable, driving up equity prices even further (Chart 5).

But two of these factors (a rising share of profits in GDP, and a reduction in the discount rate) could not be sustained indefinitely. To some extent they represented a one-off structural shift.

The share of profits in GDP cannot rise forever at the expense of wages, interest charges and tax payments. The discount rate applied to future profits cannot fall below zero.

So for a time, equity valuations could grow faster than nominal GDP as the market moved from a low-profit high-discount rate equilibrium to a high-profit low-discount one.

Once the transition was complete, however, it was inevitable that the rise in equity valuations would again be limited to the rate of nominal GDP growth (albeit from a higher baseline).

HIDDEN LEVERAGE

The rise in equity valuations was also sustained by a massive increase in borrowing and indebtedness. Share buy-backs, management buyouts and the debt-funded acquisitions by private equity firms substantially increased the amount of debt in the corporate capital structure and reduced shareholders' equity (the leverage ratio).

In effect, the long period of sustained expansion during the 1990s and the early 2000s, characterized by a mild business cycle, together with falling interest rates, increased risk appetite, and falling borrowing costs made firms comfortable taking on more debt relative to their cash flow than before.

Some of that debt was used to retire outstanding equity, heightening the leverage ratio further.

Because leverage is measured as an increase in debt (liabilities) relative to equity (residual assets) the strong rise in equity prices masked the real increase in underlying leverage.

Between 1952 and 1992, corporate debt, like equity valuations, rose roughly in line with nominal GDP. But after 1992, corporate debt, like equity values, accelerated sharply (Chart 6).

So long as equity values continued to rise, the leverage ratio remained unchanged. In fact, strong growth in equity values cut the ratio from almost 100 percent to less than 50 percent between 1987 and early 2007 (Chart 7).

But the capital structure became increasingly vulnerable to any setback in equity prices; the borrowing boom could only be sustained as long as interest rates fell and the share of profits in GDP rose.

The U.S. economy and capital markets were thus set on an unsustainable course. And as President Richard Nixon's chief economic adviser Herbert Stein noted in the 1970s, if something cannot continue indefinitely, it will eventually stop. That is what happened when the mortgage crisis erupted in the summer of 2007 and the music suddenly stopped playing.

Once rates and spreads had reached ultra-low levels in the mid-2000s they could not be reduced any further. In fact the Federal Reserve began to lift short-term interest rates, cautiously, from mid-2004, putting gentle upward pressure on longer rates. Losses on imprudent subprime lending became apparent from 2006.

Suddenly the cheap-credit dynamic that had previously supported increases in both corporate debt and equity valuations stalled and went into reverse.

The high-debt, high-equity valuation equilibrium proved immensely unstable. As the economy stalled and nominal growth fell, credit availability and costs rose, and the equilibrium fell apart. Looming deflation threatens to wreak even deeper destruction, because it would push nominal GDP growth below zero.

Suddenly the highly valued equity that supported an immense pile of debt has been re-valued downwards, sending leverage ratios soaring and exposing the underlying vulnerability.

The economy-wide leverage ratio reported by the Federal Reserve jumped 16 percentage points from 41 percent to 57 percent in just 15 months between June 2007 and September 2008. Recent declines in share values will push the ratio closer to 100 percent when data for Q4 2008 and Q1 2009 become available in the next few months.

In some sense, the sharp drop in equity valuations over the last six months has restored the historical relationship between equity values and nominal GDP. It has undone much of the "structural shift" in equity valuations to GDP experienced in the last 15 years (Chart 8).

Whether equity prices settle here or recapture some or all of their previous level depends on what caused that structural shift; how much of it proves sustainable; and how much is now reversed.

Share valuations may rise from current levels, but higher credit costs and a lower share of profits in GDP will almost certainly ensure valuations do not regain their previously elevated level in relation to the rest of the economy.

-- James Saft is a Reuters columnist. The opinions expressed are his own --

Banks in the U.S. face a new source of write-downs and failures in the coming year as loans made to developers to finance residential and commercial property development rapidly go bad.

And as these loans are old-fashioned and concentrated in smaller banks, their fate is particularly interesting as it indicates that issues with the banking system go far deeper than the so-called "toxic assets" belonging to the largest lenders that have thus far gotten most of the attention and government aid.

They are also a great illustration of the difficulties of stopping a housing and deleveraging crash.

Called Acquisition, Construction and Development (ADC) loans, they total 8.4 percent of all bank loans, just below a 30 year peak, and are used by developers to buy land, put in infrastructure and construct housing or commercial and office space.

And because they are dependent on a reasonably healthy real estate market -- someone who is willing to buy or rent the properties -- when projects are completed, they are now in deep trouble.

"Everyone in the media is focused on consumer foreclosures. What they're not focused on is the builder developer foreclosures which are only in the early innings and which will continue to wreck havoc as these assets are liquidated at depressed prices. Until they are cleared there can't be a stabilization in home prices," said Ivy Zelman, a longtime housing analyst at Zelman & Associates, who thinks the pressure will cause "hundreds of banks" to be closed and liquidated.

"The Federal Deposit Insurance Corporation doesn't have the funds to deal with all this. They don't have the scalability to deal with all these problem banks. They can't examine the smaller banks fast enough," she said.

Zelman estimates that U.S. banks risk having to charge off an additional $84 billion of ADC loans between now and 2013, equal to a hit of nine percent of Tier 1 capital.

That is damage banks can ill afford just about now, given the rising trend in delinquencies on consumer and home purchase loans, not to mention a deteriorating outlook for commercial loans.

Non-performing ADC loans hit 8.5 percent at the end of the year, up from just 3.2 percent the year before. Loans delinquent between 30-89 days are also up, by 25 percent in the quarter to 2.9 percent. And developers, struggling to try to survive without reliable cash flow from sales, are drawing down on commitments from banks that are not secured. The percentage of unsecured construction loans drawn down hit 73 percent, above the peak seen during the 1990s real estate slump and a crucial sign of builder distress.

FDIC FUNDING CRUNCH

Of particular concern is the way in which ADC loans are concentrated in smaller and community banks, which tend to have long and deep relationships with local developers. ADC loans account for 47 percent of non-performing loans at small banks as against 14 percent at larger banks.

And you can't blame mark-to-market or toxic securitizations for these losses. They are considered held-to-maturity and are not typically included in any complex securities.

Chris Whalen of Institutional Risk Analytics, which specializes in bank risk analysis, sees ADC loans as part of the difficulties banks face with commercial real estate, and believes that regulators will be forced to get tough with banks in forcing them to write down exposure to struggling firms and deals.

"It will be subject to an impairment test and than they will have to start charging it off. The regulators are already beginning to force the community banks," he said.

And while smaller banks being closed by the FDIC may not get the attention of a bailout of a big bank like Citigroup, every failure depletes resources and hurts credit availability.

The FDIC fund fell by almost half in the fourth quarter alone, touching $18.9 billion as it set aside a large portion of money for actual and expected bank failures. The FDIC has said it needs a bigger cushion but moves to impose special fees on healthy banks will inevitably hit profitability and credit availability.

Democratic Senator Christopher Dodd, chairman of the Senate Banking Committee, is moving to introduce legislation that would more than triple -- to $100 billion -- the FDIC's line of credit with the Treasury Department.

But even beyond bank failures, ADC loan woes point to the intractable problems of a real estate bust.

Banks, while trying to reduce their overall exposure to these loans, have been reluctant to pull the rugs from under borrowers because, as with a house foreclosure, they end up owning a hard-to-sell underlying asset. But more foreclosures are coming, and with them fire sales as banks compete with those developers who still are in business and with homeowners and with foreclosure sales to liquidate inventory.

That will drive land and real estate prices down further and suck others into what amounts to a negative self-reinforcing cycle.

That's true for housing, true for banking and true for the economy.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --