– Agnes T. Crane is a Reuters columnist. The views expressed are her own –

Let the trading begin.

California will be mailing out its first batch of IOUs today after the state’s stalemate over how to close the more than $24 billion hole in the budget leaves it with insufficient funds.

The IOU market could swell to $3.36 billion by the end of the month if lawmakers and the governor still can’t find a middle ground.

Big banks, which stepped into the breach 17 years ago when the state last issued IOUs, appear to be reluctant to do the same this time around. Wells Fargo & Co, Chase and Bank of America have so far said they will accept the IOUs from their customers as they would any other check, but only for a very limited period of time. All three banks say they’ll stop accepting them after a week.

For the more entrepreneurial investor, California’s newly introduced debt could be the opportunity of a lifetime, or at least of the summer.

The IOUs are registered warrants with an interest rate of 3.75 percent and a maturity date of October 2. But for the purposes of marketing, let’s just call them Terminators.

They have the potential to become what Wall Street likes to call a liquid market — a large amount of securities with similar characteristics that investors can buy or sell quickly. And given the uncertain legislative landscape, there would be an opportunity to make a buck or two.

First, the Terminators are slated to go out in batches rather than all at once, meaning that those sold in the beginning are likely to be worth more since the interest will be paid over a longer period of time. All the warrants will carry a maturity date of October 2 no matter when they’re sent out. Arbitrage anyone?

Second, the more liquid the market, the easier it is to trade. The longer the budget stalemate endures, the more Terminators will be issued. If you thought the deficit projections for July were big, take a look at August and September.

The controller projects cash shortfalls of $3.7 billion and $6.5 billion in those respective months and “double-digit freefall” after that. That means traders could swap Terminators on a daily basis, with prices fluctuating according to prevailing views on how long the crisis goes on.

That may just mean days. Or it could be for substantially longer. For the October 2 maturity date comes with a big caveat: California will redeem the securities only if it has the cash. If it doesn’t, presumably it will have to issue even more Terminators.

If the crisis does go on and there is a great big pool of these IOUs sloshing around California, what’s to stop someone from collecting, say, $500 million worth and slicing and dicing them into an asset-backed security?

Add general obligation bonds (which the state is required to service with cash) to the mix, and the bond’s triple-A slice should be adequately protected in case the cash doesn’t start flowing on October 2. On a fixed-income desk somewhere on Wall Street, someone is most likely crunching the numbers.

There is also an opportunity to claim altruistic motives. Some of the state’s most vulnerable people are at risk of having key services cut if the IOUs can’t be sold for cash.

The controller estimates that the Department of Social Services is slated to receive roughly $1.2 billion in Terminators during July alone if the impasse continues, while other social service agencies that help people with developmental disabilities and mental health issues will receive more than $400 million in warrants. By buying up these notes, investors can ensure cash will continue to flow to the underserved.

Of course, this market wouldn’t be for the faint-hearted. After all California could emerge quickly from the budget crisis, as the IOUs promise to shame lawmakers to hammer out the compromise. Then investors would most likely be stuck with the notes until October 2, and who would want that?  Certainly not Californians.

(Editing by Martin Langfield)

The California budget impasse comes to a head one way or the other this week, with state lawmakers needing to make nice by June 30 to close a $24 billion budget gap. If they don't, rating agencies have threatened to downgrade the state's credit ratings.

California's Comptroller said he would begin handing out IOUs on July 2 and the Treasurer said the state will draw on reserves to service the debt of all economic recovery bonds on July 1. (These bonds were created in 2004, when voters gave the state government the authority to raise $15 billion through bond issuance to plug another budget deficit.)

While a slump in real estate and tax revenue are very real factors behind California's disastrous finances, the San Francisco Chronicle also bullet-points more entrenched problems that have made it difficult if not impossible for the state to surmount extreme dysfunction.

-- Partisanship: California's gerrymandered legislative districts tend to protect incumbents and encourage more political extremes - Republicans on the right and Democrats on the left with less incentive to reach out to the political middle, much less compromise at the Capitol.

-- Term limits: Proposition 140, passed in 1990, limits legislators terms to six years in the Assembly and eight in the state Senate.

-- Ballot-box budgeting: Initiative-loving Californians mandated set-aside funding for all kinds of single-interest issues, from education to stem cell research.

-- Prop. 13: The 1978 landmark law slashed commercial and residential property tax rates, shifting state reliance to other more volatile sources.

-- The two-thirds majority rule: The Golden State is one of just three states that require a two-thirds majority vote from each legislative house to pass budgets.

Fitch Ratings cut California's ratings to A-minus last week from A, and warned that further action could be forthcoming if there's not a budget agreement beyond June 30.

California general obligation bonds have been getting hit as a result of all the uncertainty. In May, the bonds were trading roughly 37 basis points above AAA-rated munis, according to Municipal Market Advisors. Now they stand at 105 basis points. It's also helping to drag down the overall market, though returns for the year are still in the black at 5.2%.

The big fear of course is default, but there are many gradations about what they could mean for bondholders.  The worst case scenario would be repudiation, or simply walking away from its debt obligations, though this seems extremely unlikely given the size of the California economy (eighth in the world if it stood alone) and its dependence on future credit market financing. Then there's defaulting on the debt servicing or paying only part of it.

There's still some hope that the federal government would step in if it came to default, but the Obama Administration has been reluctant to prop up state and local governments, especially when it has its hands full with the auto industry and the financial system. It also would open up the federal government to petitions from a long line of states and municipalities also getting squeezed.

-- Neil Collins is a Reuters columnist. Christopher Fildes is a guest columnist. The opinions expressed are their own --

LONDON, April 22 (Reuters) - The Treasury is the UK government's finance ministry. There are many other government departments, but in the years since 1997, all have been turned into subsidiaries of the Treasury, the power base of Prime Minister Gordon Brown when he was chancellor.
His ambition was to micro-manage in every one of them. Today we saw the true cost of this disastrous experiment. All major countries have serious problems with their government deficits, but the most entrenched of Britain's are home-made.
Britain's public finances, which had been deteriorating for years, are wrecked. Even on his successor's rose-tinted projections, they will not return to a balanced Budget for at least the next nine years.
Given that no Treasury projection for more than three or four years out bears any resemblance to reality, and given the there will have been at least two elections between now and then, this is a post-dated cheque drawn on the Bank of Fantasy.
Alistair Darling has learned at the feet of the master of obfuscation, double counting and footling detail. So we heard all about the green recovery, from a government that sees no contradiction between raising the cost of fuel and granting tax concessions to North Sea explorers. There may be more oil there, but for the state, this is now a dry well.
The Chancellor did not dare say what he and his advisers really think about the green-tinted scheme wished on them by Peter Mandelson, the Trade Secretary, to scrap your old banger for 2,000 pounds towards a new one.
At least they managed to limit the damage to a single year. If your car is not 10 years old by next March, it will be junked in the ordinary way.
Junk is what the last Treasury forecast has now become. It's barely five months since Darling's last emergency package. It looked like a work of fiction then, and now there's no doubt. In his Budget a year ago, he was expecting to borrow 43 billion pounds in 2008/09, crowing that the previous peak was much higher, at 7.8 percent of gross national product. The sum would come down after that.
By November, there was no crowing. The projected borrowing requirement was 78 billion pounds, and was going up, to 118 billion in the following year, not down. Even those horrible figures have now been left far behind. Last year he needed 90 billion pounds, and in 2009/10, he says, it will be 175 billion pounds, or 12.4 percent of GNP.
The forecast is then for a fall, although not by much. In 2010/11 he - or his successor - will still be 173 billion pounds short of balancing the books.
So in three years the government will have borrowed 5,600 pounds for every man, woman and child in the country. That's over 20,000 pounds for what the prime minister routinely calls the average hard-working family.
In any business, from a corner shop to a multi-national, this arithmetic would be immediately fatal to those who had put it forward. Their credit would be ruined, and the business's credit could not be restored while they were still in charge.
Britain's credit is ultimately expressed in the external value of sterling, as Brown himself has said. The pound has already been devalued informally by a greater amount than the two previous formal devaluations in 1967 and 1992.
The short-term effects have been mostly benign, but the possibility of a flight from the currency is always there. This Budget makes it a little more likely.
In this context, everything else is detail. The biggest detail is the attack on what Darling describes as "those who gained the most". This is a sop to his fractious party in parliament.
From next April anyone earning over 150,000 pounds a year will be paying 51.5 percent on every extra pound earned, the highest rate in Britain for 21 years. They will also lose their tax-free allowances and half the tax relief on their pension contributions.
The small print betrays that the government is relying on these measures to bring in 7 billion a year, sometime in the middle distance. This looks as unconvincing a forecast as any in Darling's portfolio. Well-paid labour is highly mobile nowadays, and will go where the prospects are high and the taxes low.
Nothing else in the 250 pages of the Budget Report is worth a row of green beans. Even the Treasury can't put a price on the measure to reduce VAT on children's car seat bases.
Despite its name, "enhanced capital allowances" will actually raise more money -- 10 million pounds, or enough to run the government machine for about eight minutes.
Thrashing around for something cheerful to say, Darling kept telling us how much worse off other people were. To assert that "we and other countries have been battling against a succession of shocks which have hit the world economy" suggests that our luckless planet had crossed orbits with a large economic meteorite.
The former chancellor, now prime minister, assumed the sun would shine forever, and that he had somehow managed to suspend the usual rules of economics -- or as he himself put it, "no more boom and bust." In recent years, he produced growth by borrowing, pouring the money into the public services for ever-decreasing returns.
Each time he borrowed more than he had forecast. Now the bill has arrived, and it's plain that neither he nor his successor has the slightest idea of what to do. Marc Ostwald of Monument Securities summed it up within minutes: "a Budget of tinkering with the public sector financial sector meltdown, with no substance or obvious strategy whatsoever."
One day the Treasury will remember how to mind its own business, under a chancellor who grasps that until the public finances are put in order, nothing else will go right. The longer the wait, the worse will be the reckoning.

– Diana Furchtgott-Roth, former chief economist at the U.S. Department of Labor, is a senior fellow at the Hudson Institute. —

On Tuesday, President Obama suggested that his new proposed spending, if adopted by Congress, would be an investment that will pay for itself.

Mr. Obama declared: “We invest in reform that will bring down the cost of health care for families, businesses, and our government.” Such investments, he argued, will in the long run make the economy operate more efficiently.

Mr. Obama was optimistic about how his policy recommendations, if enacted, would play out.  But the nonpartisan Congressional Budget Office estimated that government spending and the deficit would grow steadily from 2012 through 2019, not only in dollars, but also as a percent of GDP.

After “bottoming out” at $658 billion in 2012—a level more than 40 percent above the highest deficit under the presidency of George W. Bush— CBO projects the deficit to reach $1.2 trillion in 2019, or 6 percent of GDP.  By 2019 government spending would take up nearly a quarter of GDP, far higher than at the peak of Iraq war spending, and the highest, except 2009 and 2010, since World War II.

Mr. Obama’s stimulus plan and budget are not one-time investments followed by years of reduced spending.  Instead, they form a platform for spending growth that continues into the indefinite future.  The vast majority of this spending is not what a well-run business or the Internal Revenue Service would count as investment—plant, equipment, and other tangible assets. Rather, most of the Obama spending would be for services.

Although Mr. Obama wants to spend and borrow more, a failed UK government’s bond auction earlier this week showed that investors are not always ready to finance the debt. And there are limits to how high taxes can rise before slowing an already fragile economy.

Alternatively, is it possible for Mr. Obama to cut spending?  Menus of changes in spending and taxes provided by CBO since 1978 suggest the answer is yes.  The latest complete volume of Budget Options was issued in February 2007, and another is due out soon.  A volume of health care options to both increase and decrease spending was published in December 2008.

CBO lists billions in savings in 10-year increments.  If only politicians had the willpower to choose among them, the budget might well be balanced. Let me assure readers that if only economists were elected to Congress, the deficit would shrink soon enough.  Of course, the economists might not be reelected.  But politicians try to woo different interest groups by spending money, with the ultimate cost falling on generations of taxpayers.

Here are a few examples of savings calculated by CBO, all over 10-year periods.

• Social security benefits are now indexed for inflation using a formula based on wage levels rather than price levels.  Changing to a price index would result in a 10-year savings of $141 billion.  Gradually raising the standard retirement age, which will reach 67 in 2026, to allow for increased life expectancies would save another $86 billion.

• Changing Medicaid payments for acute care services into block grants to states, and indexing these payments for price increases and changes in population, would save $556 billion.

• CBO estimated that giving a voucher to purchase health insurance to every uninsured family within 200% of the poverty line—that’s below an income of $44,000 for a family of four—would cost $65 billion, a savings of $569 billion over the Obama plan, which calls for a down payment on a universal health insurance fund of $634 billion.  Double the generosity of the CBO voucher, and that’s still $500 billion less in spending than the president proposed.

• Although Mr. Obama last year proposed creating a public health plan for uninsured Americans that looked like the Federal Employees Health Benefits Program, CBO calculated that replacing the FEHB with a voucher program would save $70 billion.

Other savings proposed by CBO range from $105 billion over ten years from reducing Federal aid to highways, to $13 billion from selling some Tennessee Valley Authority Electric Power assets, to $11 billion to eliminate Federal grants for wastewater and drinking water infrastructure, to savings from defense and agriculture.  All agencies are included.

In the name of investment, President Obama’s budget would increase the deficit by $4.8 trillion over the next decade.

He could serve us taxpayers better by carefully examining each line of spending and cutting the waste, as he promised us he would do during the campaign.

Click here to read a related opinion column, “To Pay for Vital Programs, Congress Must Make Tough Choices,” by Deborah Weinstein of the Coalition on Human Needs.

- Deborah Weinstein is the executive director of the Coalition on Human Needs. The opinions expressed are her own -

As the House and Senate Budget Committees begin work this week on their versions of the Congressional Budget Resolution, the usual suspects are lining up to oppose proposals that would pay for health care reform, reduce global warming, create more jobs and improve our education system. Beyond the expected Republican opposition, however, some key Democrats are also calling for changes that would seriously weaken Presidents Obama’s groundbreaking budget.

Although the chairs of the House and Senate Budget Committees are expected to craft resolutions that remain faithful to the President’s priorities, many of the revenue sources proposed by Obama are being called into question.  Further, the skittish-on-spending Blue Dog Democrats in the House and similarly inclined Senate Democrats are urging reductions in domestic appropriations, which pay for education, job training, housing, child care and child welfare services, public health, and other family and community services.

Last week’s significantly increased deficit projections from the Congressional Budget Office have provided further ammunition for those waving the banner for reduced domestic spending. In large part because the economy worsened dramatically since the Obama Administration prepared its budget, CBO projected a deficit of $1.4 trillion for fiscal year 2010 compared with the Obama budget estimate a $1.17 trillion.

As serious as the deficit is, cutting domestic appropriations is not the answer. These programs contribute minimally to the deficit, and are crucial to pulling our country out of the deepest recession in decades and creating long-term economic stability for all Americans. And while cutting waste in such areas as Medicare, military contracts and farm subsidy programs are important sources of potential savings, they won’t provide enough to fund the desperately needed shift in priorities called for under President Obama’s budget.

Instead, those who criticize the President’s proposals must come up with fair and responsible alternatives for increasing revenues and reducing the deficit over time.

The President’s budget provides a blueprint for doing just that. To pay for health care reform, for example, Obama proposes funding his $634 billion expansion of health care, which would take a giant step towards quality care for most Americans, in part by lowering the value of income tax deductions for the wealthiest households (those making more than $250,000 a year) from 35 cents on the dollar to 28 cents.  This change, which brings the rate back to what it was during the later part of the Reagan Administration, would produce $318 billion in savings over the next 10 years. When combined with the Obama budget’s $316 billion in projected savings from reduced payments to expensive private plans, it would cover much of the cost of the health care reform plan.

Although 98.8 percent of tax payers would be unaffected by the change, opposition in Congress has been swift, much of it claiming that reducing the itemized deduction for a very small segment of wealthy households would lead to a reduction in charitable giving. However, the Center on Budget and Policy Priorities found that there would be little impact, with charitable giving dropping by an estimated 1.3 percent. It also found the lower deduction rate would have a minimal effect on home-buying and home construction.

Many of the same Congressional leaders who have expressed opposition to reducing the deduction rate are also supporters of health care reform. Yet few have suggested a better way to pay for it.

Similarly, critics of the President’s proposal to reduce global warming by auctioning off permits to businesses that pollute have yet to explain how they would come up with the needed revenue. In addition to limiting greenhouse gas emissions, the plan would raise $65 billion in revenue to pay for permanent expansion of tax credits that reach the lowest-income families. These credits would reimburse families for the increasing costs of energy that will accompany efforts to reduce greenhouse gases and provide an important financial boost for the poorest families.

It is no longer acceptable for our political leaders to avoid making the tough choices when it comes to supporting government programs that make a difference to millions of people in need. Short term political gain may come to some of those who rail against increased domestic spending.  But the price will be a bleaker economic future for all Americans.

Click here to read a related opinion column, “Trillion-Dollar Deficits Are Not the Answer” by Diana Furchtgott-Roth, a senior fellow at the Hudson Institute.

–Diana Furchtgott-Roth, former chief economist at the U.S. Department of Labor, is a senior fellow at the Hudson Institute. The views expressed are her own. –

Today President Obama submits his budget outline to Congress, and, with it, a $634 billion fund for health care drawn from higher individual and small business taxes and lower reimbursements to medical providers.

Reform of our health care system is long overdue.  If you’re unemployed, or work for a small business that offers no health plan, or someone in your family has an existing illness known as a “pre-existing condition,” your main concern might be how to get health insurance.

As Obama said on Tuesday night in his address to the nation, “We can no longer afford to put health care reform on hold.”  But setting up a $643 billion fund and raising taxes in the middle of a recession isn’t necessarily affordable either.

In testimony yesterday before the Senate Committee on Finance, Congressional Budget Office Director Douglas Elmendorf presented options for controlling health care costs.  He warned that “reducing or slowing spending over the long term would probably require decreasing the pace of adopting new treatments and procedures and limiting the breadth of their application.”  That’s rationing by another name, not a comfortable concept to Americans. (To read the testimony in pdf format, click here.)

Mr. Elmendorf pointed to the current employer-based health insurance system, where health insurance premiums are untaxed income to workers, as one of the main causes of price increases.  He suggested replacing the tax exclusion or restructuring it, so that patients have more incentives to control costs.  In that way the purchase of health insurance would be similar to the purchase of home insurance or auto insurance, services that consumers appear able to purchase without major problems.

President Obama has said he will consider all proposals.  During his campaign, the centerpiece of his health reform effort was to set up a new health insurance plan, similar to the Federal Employees Health Benefits Program. It would be open to all, with “affordable” premiums and co-payments.

In addition, he proposed a new National Health Insurance Exchange to set standards and regulate private insurance underwriters. Those who could not meet the standards would close.

In a third provision, some employers who offer health insurance now would have to pay higher premiums in order to raise benefits to the level of the new public plan.  Those employers who don’t offer health insurance would be required to pay into the new plan, a new tax.

One way President Obama proposes to save health care dollars would be to encourage or require doctors and hospitals to use electronic health records.  Although privacy concerns have stalled this effort, it could save billions of dollars a year in medical error.  The stimulus bill allocates $20 billion to this effort.

Yet setting up an electronic data base raises many questions.  Can people opt out of the national database?   Should the federal government or individual states mandate one type of standard that can be shared between institutions? Can private companies be allowed to compete among themselves to offer the most convenient method to the medical community?  These questions need debate.

Obama plans to fund his $634 billion fund through higher income taxes on those making over $250,000 as well as limiting itemized deductions by 20 percent. This would be a substantial increase in tax for those households, as well as for small businesses who file under the individual tax code.

Yet even these numbers might be understated.  The insurance program for federal employees is of a higher quality and more costly that typical private-sector coverage.  Expanding health insurance and providing better care costs more money, not less.

Everyone agrees that health insurance needs to be easily accessible and portable, like auto and home insurance.  The question facing us is how to get there and how to pay for it.

Diana Furchtgott-Roth can be reached at dfr@hudson.org. For previous columns, click here.