In this week’s Credit Bubble Bulletin Prudent Bear’s Doug Noland makes a crucial point: It’s not inflation that the U.S. risks by issuing trillions of dollars of new debt, but “a crisis of confidence at the very heart of our monetary system.”

Exactly. If we keep this up the financial markets might abandon dollar-denominated assets, virtually overnight. And the only way to avoid this fate is to liquidate the debt and take the resulting pain. Here’s an excerpt:

And I find myself increasingly frustrated by the ongoing “inflation vs. deflation debate.”  With today’s low level of consumer price inflation, those arguing that deflationary forces are the paramount systemic risk now dominate policy dialogue.  Most tend to be inflationists.  Most argue for additional stimulus and see little risk in such activist policymaking.

I see risks altogether differently.  We are in the late-phase of a multi-decade historic Credit Bubble.  The greatest risk at this point is that massive issuance of non-productive governmental debt foments a crisis of confidence at the very heart of our monetary system.  The top priority must be to ensure that such a devastating outcome is avoided – and at significant unavoidable cost.  It is imperative that we as a nation come to the recognition that real financial and economic pain must be endured to protect the long-term viability of our monetary system.  The inflation rate is not the key issue.  And efforts to try to inflate our way out of structural debt problems are a lost cause.  We must instead move forcefully to rein in our deficits and avoid further debt monetization in order to protect the soundness of our money and Credit – or else risk a financial crash.

Most regrettably, Washington policymaking (fiscal and monetary) is on a trajectory that will inevitably destroy the creditworthiness of our nation’s vast liabilities. With ominous parallels to the mortgage/Wall Street finance Bubble, Federal Reserve policies have fostered Bubble dynamics throughout our Treasury, agency and debt markets, more generally.  Instead of market dynamics working to discipline Washington’s profligate debt expansion, Federal Reserve interventions ensure that a distorted marketplace again accommodates perilous Credit excess.  Our central bankers should heed Mr. Trichet’s warning.  Additional quantitative ease will only fuel the Bubble and risk calamity.

Normally, the consumer sentiment number that comes out each month seems like a piece of media fluff, far less substantial than, say, housing starts or the gold price. But today’s report is unusual enough to deserve a longer look. From MarketWatch:

Nothing happened, but the news was bad anyway

Commentary: Historic decline in sentiment comes almost without warning

WASHINGTON (MarketWatch) — It’s no secret that Americans are depressed. The economy is barely growing, job growth is anemic, raises are rare, house prices are falling, the stock market is down, and oil is spreading across the Gulf.

So, in one sense, it’s no surprise that the University of Michigan’s consumer sentiment index fell in July. See full story on the drop in consumer sentiment.

Markets Hub: Earnings euphoria fades

After an optimistic start to the week, stocks are deep in the red Friday as big name companies like Google, GE and Bank of America feed concerns about the pace of earnings growth. An undertone of discouraging U.S. economic data as well as the potential fallout from financial regulation is also weighing on stocks. Paul Vigna, George Stahl and Drew Dowell discuss.

But the magnitude of the drop — 9.5 points — was astonishing, and suggests that Americans may have hit some kind of breaking point.

The sentiment index doesn’t drop this much unless something really big shocks the economy and the national psyche. The shocking thing about this month’s decline is that nothing really shocking happened between June and July.

In the 32-year history of this survey, it’s fallen by 9.5 points or more on only six other occasions:

• October 2008: The month after Lehman Bros. collapsed;
• October 2005: The month after Hurricane Katrina hit;
• September 2001: The month terrorists attacked America;
• August 1990: The month Kuwait was invaded;
• March 1980: The month the stock market plunged and confirmed that the nation had entered a recession.Only once did the sentiment index fall so far without being accompanied by an event so big that it’s in the history books: December 1980.

In that month, much like today, Americans were anxious about the future of the economy, which had just emerged from a recession. They had elected a president who promised big changes, but the people weren’t quite sure what that meant, or whether the new policies would work. The market sold off. The economy dipped back into an extremely brutal recession soon thereafter.

History doesn’t repeat, of course. The drop in the sentiment index doesn’t mean a double-dip recession is in the cards, but it does mean consumers are fearful that everything is unraveling. They have no faith in government, or in business, or in the media, for that matter.

We could really use some good news right about now.

Some thoughts:

• The headline of the MarketWatch article is misleading. A lot is happening out there, most of it bad. Foreclosures are rising again, home sales are down (despite record low mortgage rates), empty commercial buildings are everywhere as video chains and other retailers close. And — the big one for readers of local papers — dozens of state and local governments are broke and threatening to lay off teachers, cops, and garbage collectors. The U.S. is rapidly becoming a Third World country, and people feel it even if they don’t always understand exactly how it’s happening.

• The designation of Americans as “consumers” still makes me uncomfortable. Why not compile sentiment stats for entrepreneurs or scientists or teachers or some other socially beneficial group, instead of putting shoppers at the center of the cultural/economic universe? Not that you’d get a positive reading from these other groups, but at least we’d be focusing on people who produce something of value.

So the real question isn’t why consumer sentiment is down, but why it was up in the first place.

For the first time in 250 years, politics has become irrelevant. Not uninteresting or unimportant; obviously the way a society organizes itself matters to its citizens and its place in the world.

But today there are no policies left on the “possible” menu that will save us from what’s coming. So a rational person’s time is better spent preparing rather than debating.* (Later, when we’re trying to decide what to build from the rubble, the argument will get interesting again.)

The most recent batch of election and poll results illustrates this point:

Poll blow raises Japanese economy fears
Naoto Kan has been Japan’s prime minister since only last month, but already he has been dealt a stinging rebuke by the electorate. His Democratic Party of Japan (DPJ) and its tiny coalition ally lost their majority in the upper house of parliament. Japan has already suffered two decades of economic stagnation; now it faces political stagnation too unless Mr Kan can persuade small parties to help him pass laws.

Centre-left rise in German state underlines Merkel woes
The Social Democrats and Greens took over Germany‘s most populous state, North Rhine-Westphalia, on Wednesday in a minority government the centre-left says could one day challenge Chancellor Angela Merkel at federal level.

At a time of weakness for conservative leader Merkel nine months into her second term, the Social Democrats (SPD) speculate that they and the Greens could form a minority German government after the next federal elections due in 2013.

L’Oréality check
Nicolas Sarkozy’s approval ratings have hit a record low in recent weeks

Should Republicans Take Control of Congress?
According to a new ABC News/Washington Post poll, registered voters are increasingly critical of President Obama’s work on the economy, and by an 8-point margin they say they’d prefer to see the Republicans take control of Congress. It’s a clear sign of GOP opportunities and Democratic risks going into the 2010 midterm elections, with 51 percent of poll respondents saying they would rather have Republicans run Congress “to act as a check on Obama’s policies.”

So what’s happening? Just a few years — in some cases just a few months — after sweeping into office with promises of “change” and a quick clean-up of their predecessors’ messes, leaders of major democracies from across the political spectrum are being swept right back out.

Did they turn out to be incompetent, or their policies wrong-headed? There’s hardly been enough time for either verdict. But if not that, what?

The answer, in a word, is debt. When an economy’s borrowing passes an historically identifiable point it loses the ability to navigate from crisis to solution. In the case of Europe, Japan, and the U.S., the range of choices has narrowed to only two, inflation and austerity, and neither is working.

When Europe tried inflation by promising to bail out the PIIGS countries, the euro collapsed, as the global markets correctly saw an oversupply of paper currency on the horizon. When it switched to austerity, workers across the continent saw their livelihoods threatened. Either way, the folks in charge get blamed and have a tough time holding their jobs.

In Japan, public debt keeps soaring no matter who is in charge. The government, believe it or not, will borrow more this year than it raises in taxes. So the newly-elected Prime Minister proposed doubling the national sales tax to 10% and then backed off in face of falling poll numbers, thus becoming a tax raiser and a ditherer, a combination that hardly ever wins popularity contests.

The U.S. government has been flooding the system with liquidity for two years, but unemployment remains in double digits. Three of the five biggest states are functionally bankrupt and will either lay off hundreds of thousands of workers in 2011 or receive a bailout that will dwarf what Goldman and AIG got last year.

The next round of elections will bring either new leaders or old ones who adopt the other side’s ideas in order to hold power. Either way, the death spiral of the military industrial complex/welfare state/fiat currency system will continue, and accelerate.

A really depressing band called Garbage said it pretty well:

It’s All Over But The Crying

Everything you think you know baby
Is wrong
And everything you think you had baby
Is gone

Certain things turn ugly when you think too hard
And nagging little thoughts change into things you can’t turn off
Everything you think you know baby
Is wrong

It’s all over but the crying
Fade to black I’m sick of trying
Took too much and now I’m done
It’s all over but the crying

* But there is a bright side. Make the right decisions now and the coming mess can be profitable (though it still won’t be fun). In 2006, shorting the housing/banking sector made a few prescient people rich (read The Big Short). In 2001 those who saw the Fed easing in response to the tech crash and loaded up on gold now have five times their original capital. In 1999 shorting tech stocks was both obvious and worth a quick fortune. So the question isn’t whether another disaster is coming — it clearly is — but whether we’ll be among the people who look like geniuses when the dust clears.

When you run a website that contains Google ads you constantly have to watch out for penny stock hustlers promising ludicrous returns. They’re generally “pump and dump” operators who push up the price of thinly-traded stocks and then bail, leaving their hapless clients holding worthless paper. Dirtbags, in other words.

So it was with some interest that I heard of a young guy named Timothy Sykes who tracks the pumpers and shows clients how to bet against them. We did a quick Q&A last week; here’s an edited transcript:

Dollar Collapse: How did you figure out that penny stock scammers were easy targets, and how did you learn to prey on them?

Timothy Sykes: I actually made my first million buying the stocks they were pumping and only when that strategy stopped working did I get into short selling the same pattern on the way down…that’s the beauty of pump and dumps, you can either buy the pump or short sell the dump, or when you get good enough, trade the stocks both ways.

It’s far easier to buy on the way up, but after a decade of trading these shady stocks, I am really only comfortable betting on their inevitable failure as experience teaches me they all fail eventually. 

DC: Walk us through some of your biggest trades.

TS: When you make millions of dollars over the year by adding up tons of $5,000 and $10,000ish profits, there’s a lot of great trades to discuss, but I can think of two that really stand out, both are detailed in my book An American Hedge Fund.

Back in 2000, when I was a college freshman, the pumps were truly grand and I was on my way to earning $700,000 from my dorm room simply by buying microcap stocks when they broke out to new highs on strong volume. A simple technical pattern worked like a charm over and over and over and I wasn’t even very good at holding for more than 10-20% when in fact these stocks were spiking 50%+ within hours or days AFTER the technical breakouts occurred.

One such company was Illiinois Superconductor (ISCO at the time) which claimed to invent a product that would extend cell phone reception. The stock had tripled from $5 to $15 when they announced on a Friday morning press release they would be featured over the weekend on national news. The stock surged to the $17s in anticipation of great exposure and I bought 10,000 shares at $17, which was ¾ my net worth at the time, with the goal of selling into a Monday morning gap at $19, $20 or $21.

The news, using a very scientific approach, naively hyped this as the next Microsoft and I couldn’t wait to get out first thing Monday morning. I was using Scottrade back then and they didn’t have premarket trading so as the stock rose 19, 20, 21, 22, 23, I could do nothing but wait for the opening bell and when I finally got out at 9:40am (it took 10 minutes to execute since the trading volume was so overwhelming), I had sold my shares above $29 for a gain of $123,000. I celebrated by taking my entire dorm out to dinner that night. The best part was that I didn’t have to rush out as the stock nearly touched $40 the next day before gradually fading into oblivion as the product bombed.

So I was fortunate not to know about short selling then or else I would have surely been squeezed into bankruptcy before being proven right. But by 2004 I had learned how to short sell the very same pump and dump-type patterns and when the Asian tsunami hit in late 2004, I was ready to short any and all pumps and there were several.

I focused mainly on short selling a company called Taylor Devices Inc. (TAYD) as the stock had surged from $2 to $6 on rumors that Asian governments would use their earthquake absorption technology. I thought that preposterous given the company’s near-bankrupt state and shorted heavily in the $6s expecting to cover in the $4s. Unfortunately I learn the hard way that hype, like that with ISCO going to $40 before dropping back down to $15 within a week, can last longer than expected and I covered in the $7s and low $8s for a $180,000+ loss.

I know, I know, this is supposed to be great trades, but this was one of my best lessons and it got even better when I stuck to my guns and shorted again the next day in the high $8s and covered in the $6s for a gain of $250,000+ locking in total gain of $70,000, a horrible way to make that money, but a very decent haul for my small hedge fund at the time.

Now I have refined my strategy to focus more on paid-for stock promotion and I don’t go for home runs nor do I strike out so much, but it’s amazing that these patterns are still the exact same. I wish there was somebody like me teaching back when I first started as I would have enjoyed much greater success and not made so many bone headed trades!

DC: How do you short penny stocks? My broker won’t me let short anything under $5.

TS: This is the biggest obstacle to implementing my strategy and the problem is that most brokers out there absolutely stink for short selling penny stocks because they don’t want their customers partaking in such a “risky” strategy. That said, if you learn the rules I’ve learned the hard way over the years, the risk is lessened, so I use and recommend Thinkorswim, Sogotrade and Interactive Brokers. Sometimes all three brokers have shares to short, sometimes none of them do. Because I know the odds of successfully short selling a pumped up microcap or smallcap company if timed properly are around 80%, I try to reserve shares to short every day. I even came up with the term “ALFSS” which means Always Look For Shares to Short as it costs nothing but a few minutes to ask your broker if they can find shares to short each day.

DC: How do you track the pump-and-dump artists?

TS: I use several screens on StockFetcher.com and StockCharts.com and I also use great websites like StockPromoters.com and StockReads.com which spell out the compensation various promoters receive for their pumping these carcass companies, highlighting only the upside, and exaggerating as much possible, ignoring the reality that any company that is willing to pay six or even seven figures for stock promotion stinks more than cheese left out of the fridge for three weeks.

Over the years it gets easier to spot the hype and manipulation, which is why I want to get people started learning ASAP so they can become master detectives like me.

DC: Are the pumpers adapting to your strategies?

TS: No, lucky for me, penny stock CEOs and stock promoters are some of the absolute dumbest people you will never hope to meet, they are truly mental midgets. There was a CEO who had lost his medical license and in a blog post aimed at trying to discredit me, accidentally admitted to an SEC investigation just a few days before the SEC halted their stock!

I’ve seen companies that have recycled press releases from bankrupt companies while also copying that bankrupt company’s privacy policy for their website and forgetting to change the company name. SpongeTech insiders are out on $2 million bail and are alleged to have sold 2.5 billion shares thanks to the forging of legal documents signed by a fictitious lawyer and one of their “biggest customers” had the same fax number as SpongeTech executive! This niche is a comedy show and anyone with the slightest bit of intelligence has “an edge” to be able to turn the comedy into predictable profits.

The SEC has and will continue shutting down the most blatant frauds, but manipulation and pumping and dumping will always exist in some form or fashion. I will always be around to teach people to profit from it legally, by short selling these frauds and pumps and even buying them on the way up if you can be quick. Modifying a famous Jesse Livermore quote slightly “The frauds change, the players change, but Wall Street manipulation never changes.”

DC: What do you offer people who would like to try this themselves?

TS: I’ve created 10 comprehensive instructional DVD packages with over 100 hours of instructional content from the basics to advanced, the right and wrong trade setups & chart patterns, how I research and spot red flags and frauds, what data is important, etc. I also have 4 newsletters so everyone can follow along each day as I present potential trade candidates and share my real-time trade alerts.

But if I can teach people one thing, it’s to never trust anybody in finance so rather than just hearing me talk about my strategy, sign up to my free video lesson series so you can learn from the specific trades and patterns themselves.

Full disclosure: The above link is to an affiliate program that pays for referrals, so before buying a video or subscribing to a service do enough research to be sure you understand what you’re getting.

Here’s a piece on municipal bonds by Rich Bookstaber, an SEC adviser and author of Demon of Our Own Design, a well-received book on derivatives. The article is a few months old, but — since the muni market has yet to blow up — it’s still timely. See the last paragraph for a succinct explanation of the main risk to muni holders in particular and the economy in general.

The Municipal Market
This represents my personal opinion, not the views of the SEC or its staff.

My first blog post was in June, 2007. It was titled “What sorts of crises am I worried about now”. My answer was housing and credit. With the benefit of hindsight, this might be considered a no-brainer, although at the time it was not so clear where things would go.

Now as the dust settles from the crisis that emerged in 2008, we can start to think about what might come next. And yes, the crisis really is settling down, despite the alarmists who, thinking we were in a 1930’s style depression, pushed the panic button and stuffed their mattresses (or portfolios) with cash. For whatever reason, be it astute government intervention or the natural healing process, we are looking back at something along the lines of a bad, credit-driven recession.

I don’t think we will see a big crisis emerging for some time in banks, hedge funds or derivatives, mostly because, like with a knockout punch, the risks that matter don’t come from where you are looking. Unless the current push for legislation is a failure, which, of course, still remains to be seen, we will have steely eyes hovering over these sources of crisis. It will be awhile before the guards start dozing off at their posts.

So, where to look next. To see other potential sources of crisis, let’s first recount the lessons learned from this crisis:

1. Problems occur when things get leveraged and complex (and thus opaque).
2. If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.
3. The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), works fine – until it doesn’t.
4. A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.
5. Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
6. Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn’t. Income that was supposed to be there to finance the mortgages – even when that income was fairly stated – became committed to other areas (like second mortgages). .

Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?

Answer: The municipal market.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky — the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the under funded portion of the portfolio.

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Oh, and just as homeowners took their income and locked it up via secondary loans, much of the tax base for municipalities is already mortgaged, through the sale of tax-related revenues streams like tolls and parking fees. Indeed, although general obligation bonds are considered the cream of the crop, they might just as well be regarded as the residual claim after anything with solid fee streams has been sold off.

Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened, all the more so if the defaults are spurred along by a taxpayer revolt – democracy at work.

In this recent CNN interview, Harvard Professor Niall Ferguson predicts that, barring a radical change in policy, “nasty fiscal arithmetic” will send the U.S. into a “death spiral.” Some representative quotes:

“Fiscal tightening is baked in the cake. Tax increases are coming and coming soon… The US has a kind of stay of execution while the European crisis unfolds, but at some point the nasty fiscal arithmetic will get everyone, including the U.S… Treasuries are a safe haven the way Pearl Harbor was a safe haven in 1941. It’s safe until it’s not safe anymore.”

Saturday’s New York Times has an article on Illinois’ finances that is must reading for anyone who thinks the U.S. has turned the corner. The crucial takeaways are 1) even though states can’t technically declare bankruptcy, they apparently can just stop paying their bills, 2) while salaries and pensions for current public sector workers are untouched, services that provide lifelines to the most vulnerable are being decimated, and 3) though Illinois is arguably the worst-run state, a whole bunch of others are close behind, so what happens there will soon be replicated across the country.

Illinois Stops Paying Its Bills, but Can’t Stop Digging Hole

CHICAGO — Even by the standards of this deficit-ridden state, Illinois’s comptroller, Daniel W. Hynes, faces an ugly balance sheet. Precisely how ugly becomes clear when he beckons you into his office to examine his daily briefing memo.He picks the papers off his desk and points to a figure in red: $5.01 billion.

“This is what the state owes right now to schools, rehabilitation centers, child care, the state university — and it’s getting worse every single day,” he says in his downtown office.

Mr. Hynes shakes his head. “This is not some esoteric budget issue; we are not paying bills for absolutely essential services,” he says. “That is obscene.”For the last few years, California stood more or less unchallenged as a symbol of the fiscal collapse of states during the recession. Now Illinois has shouldered to the fore, as its dysfunctional political class refuses to pay the state’s bills and refuses to take the painful steps — cuts and tax increases — to close a deficit of at least $12 billion, equal to nearly half the state’s budget.

Then there is the spectacularly mismanaged pension system, which is at least 50 percent underfunded and, analysts warn, could push Illinois into insolvency if the economy fails to pick up.States cannot go bankrupt, technically, but signs of fiscal crackup are easy to see. Legislators left the capital this month without deciding how to pay 26 percent of the state budget. The governor proposes to borrow $3.5 billion to cover a year’s worth of pension payments, a step that would cost about $1 billion in interest. And every major rating agency has downgraded the state; Illinois now pays millions of dollars more to insure its debt than any other state in the nation.

“Their pension is the most underfunded in the nation,” said Karen S. Krop, a senior director at Fitch Ratings. “They have not made significant cuts or raised revenues. There’s no state out there like this. They can’t grow their way out of this.”

As the recession has swept over states and cities, it has laid bare economic weakness and shoddy fiscal practices. Only an infusion of federal stimulus money allowed many states to avert deep layoffs last year.

Cuts in Work Forces

The federal dollars are nearly spent. Last month, local governments nationwide shed more than 20,000 jobs. Should the largest struggling states — like California, New York or Illinois — lay off tens of thousands more in coming months, or default on payments, the reverberations could badly damage a weakened economy and push housing prices down still further.

“You’re not seeing these states bounce back, and that could be a big drag on the national economy,” said Susan K. Urahn of the Pew Center on the States. “It could be a very tough decade.”

In Illinois, the fiscal pain is radiating downward. From suburban Elgin to Chicago to Rockford to Peoria, school districts have fired thousands of teachers, curtailed kindergarten and electives, drained pools and cut after-school clubs. Drug, family and mental health counseling centers have slashed their work forces and borrowed money to stave off insolvency.

In Beardstown, a small city deep in the western marshes, Ann Johnson plans to shut her century-old pharmacy. Because of late state payments, she could not afford to keep a 10-day supply of drugs. In Chicago, a funeral home owner wonders whether he can afford to bury the impoverished, as the state has fallen six months behind on its charity payments, $1,103 a funeral.

In Peoria — where the city faced a $14.5 million gap this year and could face an additional $10 million budget hole next year — Virginia Holwell, a trainer of child welfare caseworkers, lost her job when the state cut payments to her agency. She sits in her living room high above the Illinois River and calculates the months of savings left before the bank forecloses on her house.

“I’ve got enough to last until the end of August,” she says, matter-of-factly. “I’m 58 and I’m pretty good at what I do, and I got to tell you, I’m pretty devastated.”

Public colleges and universities occupy a fiscal sickbed all their own. This year they muddled through without $668 million expected from the state; the University of Illinois has yet to receive 45 percent of its state appropriation. Legislators made no pretense of promising to pay this bill soon. Instead they authorized colleges to borrow against the expected state payments.

“The big fear is that next year we’ll be down twice as much,” said Randy Kangas, an associate vice president of the university. “No one knows how to make the cash flow work.”

Illinois legislators tend to plead victim to economic circumstance, and the state’s maladies are considerable. In 2006, the Illinois unemployment rate stood below 5 percent; now it is near 11 percent, and the percentage of long-term unemployed exceeds the national average. Major manufacturers have eliminated thousands of jobs, and the state ranks in the top 10 nationally in foreclosures.

Five years ago, the Chicago suburb of Tinley Park issued about 650 home building permits; last year it processed one. The city of Rockford plans to close fire stations and lay off firefighters, and in Decatur, 180 impoverished seniors have lost their delivered meals. The lakeshore condo towers in Chicago bespeak affluence, but there are so many foreclosures on the bungalow blocks of southern and western Chicago that “for sale” signs sprout like sunflowers.

Few budget analysts are surprised to see Illinois, with a limping economy and broken political culture, edge close to the abyss. Two of the last six governors have served jail terms, and a third is on trial.

“We are a fiscal poster child for what not to do,” said Ralph Martire of the Center for Tax and Budget Accountability, a liberal-leaning policy group in Illinois. “We make California look as if it’s run by penurious accountants who sit in rooms trying to put together an honest budget all day.”

Stopgap Solutions

The Community Counseling Centers of Chicago is another of those workaday groups that are like the stitches on a baseball, holding together poor and working-class neighborhoods. With an annual budget of $16 million, the agency tends to families torn by crime and violence as well as people who are psychologically stressed and abusing drugs.

On any given Monday morning, the agency’s chief administrative officer, John J. Troy, 61, has no idea how he is going to keep its doors open until Friday. He said the state had not come through with an expected $2.2 million, which is about six months of arrears. He has laid off and recalled employees three times in the last two years.

“Two weeks ago, I had days to meet my $420,000 payroll and all I was looking at was a $200,000 line of credit from a bank,” recalled Mr. Troy. “I drove down to Springfield and said, ‘Hey, you owe us $3 million.’ They said: ‘Oh, that’s nothing. We owe another agency $10 million.’ ”

“The fact of the matter is,” he added, “I don’t sleep much these days.”

Illinois’s fiscal practices are thoroughly fractured. Large agencies survive from one payday to the next. Small agencies seek high-interest loans from out-of-state finance companies.

The state pension system is a money sinkhole and the most immediate threat. The governor and legislature have shortchanged the pensions since the mid-1990s, taking payment “holidays” with alarming regularity.

The state’s last elected governor, Rod R. Blagojevich, is on trial for racketeering and extortion. But in 2003, he persuaded the legislature to let him float $10 billion in 30-year bonds and use the proceeds for two years of pension payments.

That gamble backfired and wound up costing the state many billions of dollars. Illinois reports that it has $62.4 billion in unfunded pension liabilities, although many experts place that liability tens of billions of dollars higher.

Legislators this year raised the retirement age and slashed benefits. Though changes apply only to future employees, the legislature claimed immediate savings.

“Savings upfront and reforms down the road,” said Mr. Hynes, the state comptroller. “It’s just bad habits and bad practices.”

More broadly, Illinois is caught between blue state convictions about social safety nets and a red state aversion to taxes. For years, the Democratic-controlled legislature has passed budgets that are, in effect, in deficit. Lawmakers routinely skip around the state’s balanced-budget law, with few consequences. (Republicans are near monolithic in voting against any tax increases and borrowings. When one broke ranks to try to keep the pension solvent, he was stripped of a committee position, reducing his pay and pension.)

“The pension move was Enron-esque,” said Mike Lawrence, a press secretary to the former Republican governor Jim Edgar, who was the last governor to sign an income tax increase. “Blagojevich was not a tax-and-spend governor; he was a spend-and-borrow governor.”

The state’s income tax burden is not terribly high — Illinois ranks in the bottom half of states — and its government is not terribly large. (The budgets in New York and California, per capita, are much larger). Even if the state cut out all family and human services spending, more than half of the budget deficit would remain.

As comptroller, Mr. Hynes has trained his attention on the public and nonprofit agencies that rely on state money; he tends to roll his eyes at the notion that slashing alone is a solution.

“Only the most delusional people think you can solve this without raising taxes,” he said.

The legislature has a different instinct: to borrow. In good times, that leads to unsightly imbalances. In bad times, it becomes catastrophic. This year, leaders gave the governor authority to move money around and left town to campaign.

“Each budget has gotten historically worse during this recession,” said Laurence Msall, president of the Civic Federation, a policy research organization. “We’ve borrowed more and pushed larger unpaid bills into the future.”

Illinois spends a minor fortune papering over its budget holes. Last year, the comptroller’s office paid $55.3 million just in interest on two short-term borrowings to pay the state’s bills.

The local video store is closing, and the other day I wandered in to pay our remaining late fees (eight bucks for a single video that spent a week under the couch). I was the only customer, so the guy at the desk had time to tell me about his store’s demise. Turns out that this isn’t just a single under-performing store folding, but the whole company, Movie Gallery, closing all 1,900 of its Hollywood Video and Movie Gallery stores. I said something like, “Man, that’s a lot of empty commercial space,” and he said he’s heard that the liquidator in charge of this wind-down is negotiating with Blockbuster, the biggest video chain, for the same services. So we’re talking thousands of mostly prime-location storefronts.

But big as it is, the evaporation of bricks and mortar video rental could be passed off as run-of-the-mill creative destruction, as better technologies drive DVDs off the field. As such, it’s not a reliable indicator of commercial real estate in general, and not really blog-post worthy.

Then this came from a friend in Washington State:

I’ve been watching all of the empty commercial real estate around the development where I work. It is pretty sad and some of these places have been empty for 2-3 years! Most of the smaller single units all went under in the last year or so. I took a quick ride around today with a camera and I thought I’d share!

ALL properties pictured are right in here, maybe a square mile? The location is right off 405 in North Bothell at the Canyon Park exit. I’ve been there for a few years and seen some of these empty for 2-3 years. The former Icos building had been empty the entire time but recently someone finally moved in there but I don’t see many cars in the parking lot so they must be small. No pictures of that one. Here is as detailed a rundown as I can give on the attached PDF file with the pictures:

Pic 1 was vacated by DHL when they went under. It has been empty ever since.

Pic 2 is the former Safeco building

Pic 3 unknown, empty as long as I’ve been there

Pic 4 details unknown empty a long time

Pic 5 a HUGE long ass building maybe 100 yards long, possibly subdivided but ALL empty

He sent many, many more pictures, but these five give a sense of what that office park — and many other office parks — must be like. Local and regional banks are on the hook for most of the loans associated with these empty buildings and those losses will be huge when they’re finally recognized.

This week the focus shifted from Europe, where (apart from the French World Cup team) things are quiet, to the US, where state budget deadlines are forcing some tough, and occasionally bizarre, choices. Time Magazine’s cover, for instance blares “The Broken States of America”. An excerpt:

… Almost no one — and no place — is exempt. Nearly everywhere, tax revenue plummeted as property values tanked, incomes dwindled and consumers stopped shopping. Falling prices for stocks and real estate have made mincemeat of often underfunded public pension plans. Unemployed workers have swelled the demand for welfare and Medicaid services. Governments that were frugal in the past are just squeaking by. Governments that were lavish in the good times, building their budgets on optimism and best-case scenarios, now risk being wrecked like a shantytown in an earthquake.

How the Money Ran Out
For the first time in four decades of collecting data, the National Governors Association (NGA) reports that total state spending has dropped for two years in a row. In hard-hit Arizona, for example, the state budget has sagged to 2004 levels, despite blistering growth in population and demand for government services. Starting with the 2008 fiscal year, state governments have closed more than $300 billion in cumulative budget gaps, with another $125 billion already projected for the coming years, says Corina Eckl, fiscal-program director at the National Conference of State Legislatures (NCSL). Similar figures aren’t collected for the nation’s counties, villages and towns, but when the National League of Cities surveyed mayors recently, three-fourths of them described worsening economic conditions.

Accustomed to the ups and downs of the ordinary economic cycle, elected officials and budget planners are facing something none of them have experienced before: year after year of shortfalls, steadily compounding. Ordinarily, deficits are resolved mostly through budgetary hocus-pocus. But the length and depth of the recession are forcing governments to go beyond sleight of hand to genuine cuts. And that makes lawmakers gloomy in all but a handful of states. (It’s a swell time to be North Dakota.) According to an NCSL survey, worry or outright pessimism is the reigning mood in the vast majority of capitals.

And here’s a brief look at how some states are dealing with their deficits, starting with California:

A three-way stalemate over California’s budget

Budget, budget, who’s got a budget?

The governor has a state budget that his fellow Republicans more or less support. Assembly Democrats have a budget whose centerpiece is a complex scheme to borrow billions of dollars. And Democratic senators have a budget that’s based on raising taxes and shifting some programs from the state to counties.

Democrats control the 10-member, two-house conference committee that’s supposed to be reconciling all three budgets into one version that would be placed before the entire Legislature. They have the votes to do it. However, the committee has been going through the budget page by page for more than two weeks without settling any big issues and only some little ones. It’s now in hiatus after repeatedly hitting a political wall, unable to proceed because it doesn’t know how much money it has to spend.

That’s because the two Democratic versions of the budget are very much at odds, even if they both agree on rejecting Gov. Arnold Schwarzenegger’s slash-and-burn approach to closing a $19.1 billion deficit. It’s a three-way stalemate, with the new fiscal year due to begin next week and with state Controller John Chiang warning that the state will run out of cash this summer if a new budget is not in place.

Nothing will happen until Democrats in both houses are in sync on whether to borrow or tax their way out of this year’s version of the chronic deficit. But even if they do – and they appear to be very far apart – it would be merely a step, and not a particularly big one, on the budget road. They could put a budget up for floor votes, but they would still need to get some votes from Republicans, who have said anything that depends on higher taxes, or even extending some temporary taxes due to expire next year, is dead on arrival.

California budget idea: Ads on e-license plates

California’s legislature is exploring the feasibility of electronic license plates with digital ads, a move that its leading proponent says could add jobs and help in combating the state’s budget crisis.

Sen. Curren Price, a Democrat from the Los Angeles area, said the technology will resemble traditional license plates, with plate numbers visible at all times. However, digital ads and public service announcements would flash on the plate’s screen when the vehicle is stopped for more than a few seconds.

The technology could provide an additional source of revenue for the cash-strapped state, according to Price, the bill’s author, as advertisers and technology companies contract with the Department of Motor Vehicles. He said the plates could also aid small businesses and add jobs to the ailing economy in the technology, sales and marketing, and service industries.

“State governments are facing unprecedented budget shortfalls, and are actively rethinking the use of existing state assets to create new ongoing revenue opportunities,” he said. “This is a unique opportunity for public-private partnership.”

However, Price said he doesn’t know how much revenue electronic license plates would generate, or how many jobs they would create. California’s budget deficit is an estimated $19.1 billion.

New York:

Cigarette Tax Increased to Keep State Running

New Yorkers who like to smoke will have to dig a little deeper to light up next month, after the Legislature passed a bill on Monday that will give the state the highest cigarette taxes in the country. The new law, part of an emergency budget measure to keep the government running, adds another $1.60 in state taxes to every cigarette pack sold starting on July 1, pushing the average price of a pack to about $9.20. The average price in New York City, which imposes its own cigarette taxes, will be even higher, nearly $11 a pack.

Those who prefer other tobacco products will also be forced to pay significantly more. The tax on smokeless tobacco will more than double, to $2 an ounce from 96 cents an ounce, starting on Aug. 1. And the wholesale tax on cigars, dips and other kinds of tobacco will rise to 75 percent from 46 percent .

And in what may be the legislation’s most controversial provisions, starting on Sept. 1, the state will begin collecting — or try to collect — taxes on cigarettes sold on Indian reservations to off-reservation visitors, an issue that led to violent protests during the early 1990s. One Indian chief has said that trying to collect taxes would be considered an act of war.

Massachusetts:

Hill eyes another savings draw to blunt cuts if no federal funds

BOSTON — Girding for the start next week of a new fiscal year amid growing uncertainty about nearly $700 million in federal aid, legislative budget writers tentatively plan to withdraw $100 million from the state’s atrophying main savings account while refraining from deeper reductions in aid to cities and towns.

Gov. Deval Patrick and legislative leaders met Monday and discussed Beacon Hill’s narrowing menu of options for coping with Washington’s reluctance to authorize Medicaid funds that the administration, House and Senate all banked on for fiscal 2011. House budget chief Charles Murphy said the budget intended for the floor this week would contain two sets of line items, one in case the funds do not arrive and one if they do.

State lawmakers acknowledged not having much insight into Congress’s plans for the money, part of a $24 billion package that has received backing at one time or another from both legislative branches and the White House. “Frankly, they’ve recessed until this week sometime, so nobody knows,” Murphy said.

“We haven’t given up on it,” Patrick told reporters Monday. “I don’t think we should give up on it, given the fact that both the U.S. House and the U.S. Senate have voted on it. But if we don’t have it in hand by the time of the fiscal year, then we should have a budget that doesn’t account for it.” The Senate accounted for $687 million in additional federal assistance, while both Patrick and the House used $79 million less. In filing a contingency budget last week, Patrick, who has taken heat from his gubernatorial rivals for his budgeting practices, proposed holding harmless state support for local aid and public schools.

Colorado:

More state budget cuts likely, officials forecast

Colorado is looking over the edge of a $1 billion budget abyss, with key services, from schools to health care for the needy, on the chopping block next year. In a clear sign that economic recovery is not keeping pace with demand for governments services, economic forecasters warned a General Assembly budget committee on Monday that the state fiscal picture has worsened in the past three months and could be darker still in a year.

Economic forecasts prepared by the Governor’s office and by advisers to the General Assembly backed away from optimism seen earlier this year. They outlined a $1 billion crisis for the budget year that begins July 1, 2011.State revenue fell from a March economic forecast by more than $120 million, largely because tax collectors are having a difficult time getting people and businesses to pay up. That cuts into the state’s savings account, leaving Gov. Bill Ritter to come up with as much as $75 million in immediate cuts from the state’s $7 billion general fund.

On Monday, Gov. Bill Ritter said he is scouring the budget to cover the shortfall, with a plan due by August. He covered bigger shortfalls last year by furloughing state workers, cutting programs and releasing some inmates from state prisons. Ritter said that in the past two years he’s done his best to preserve essential state services while closing budget gaps totaling $3.5 billion. “As you go forward it becomes increasingly difficult to find ways to do that,” he said.

Colorado Springs Democratic Sen. John Morse has been predicting deeper budget cuts for months.

“Colorado is recovering, but, as predicted, it will be a slow and long recovery,” he said Monday. “While more cuts are inevitable, we, as legislators, must do what we can to make those cuts as painless as possible.”

New Jersey:

Budget compromise reached in N.J.

New Jersey Gov. Chris Christie and lawmakers reached a compromise on a $29.38 billion state budget Monday, which is scheduled for final votes on Monday.

The budget will make funds available for approved, shovel-ready Urban Enterprise Zone projects and uses $74 million in additional cost-savings to restore funding for several programs, including $22 million for general assistance. The budget plan, which closes a $11 billion deficit, will leave a more than $300 million surplus, Christie said.

“This budget stays true to the principles I originally outlined, keeping spending within our means and restoring fiscal order without raising taxes,” Christie said.

The state’s budget is due by June 30, a deadline Senate President Stephen M. Sweeney, D-Gloucester/Cumberland/Salem, said would be met.

“The budget we will introduce is far from perfect and will still be a tough sell among Democratic lawmakers, but the governor should be commended for working with us to take the sting our of some of its most harmful cuts,” Sweeney said of the budget compromise reached with Christie. “Most importantly, this budget will be signed on time, and all the rumors of a shutdown will remain just that.”

Some thoughts:

• It’s clear who is serious and who isn’t. New York raises cigarette prices to 11 bucks a pack, and expects higher revenues rather than increased smuggling and a more powerful mafia. Massachusetts spends its savings while hoping for a federal bailout. And let’s not even bother with California. At the other end of the spectrum are Colorado and New Jersey, where real cuts will bring budgets closer to real balance.

• It’s also clear that sometime in the next year or two, the worst-run states will balk at laying off half their workers and will choose instead to default on their debt, presenting Washington with the same choice as with the banks in 2008: bailouts or contagion.

• Even where states make real cuts in spending, the resulting economic contractions will be brutal.

• Muni bonds, which are funded by sport stadiums and the like — or by state/city general revenues — are the next sector to blow up.

Here’s a wake-up call from Gary North of the Ludwig von Mises Institute on why our idea of retirement will turn out to be a cruel joke. A few quotes:

Social Security will go bankrupt…The average American is going to have a miserable retirement. There’s not much a recent retiree can do. They’ve walked into the trap and it has sprung on them. The greatest losers will be widows, who are almost completely unprepared for what will take place. For most children there will be no inheritance, and parents may become an economic liability on them years before they’re prepared.

First, North runs the numbers on America’s main social programs and shows that they’re doomed. Then he explains what this means for typical citizens — which of course is horrendous. Then he offers suggestion for avoiding this fate.

A lot of people on the sound money side of the spectrum already know much of this, at least in general. But for those who think everything is basically okay and expect a comfortable government-funded retirement, the next 90 minutes could be a life saver.

The linked image below will take you to the page with the video: