With the bond market in a fuss over the caliber of its gift from the Fed, equities gave back some of their recent gains. For the week, poor performance from Disney, GM, and Honeywell pushed the Dow 2.3% lower. The S&P 500 followed suit, giving back 2%. The Transports fell 1% and the Utilities were pared back by 2%. The Morgan Stanley Cyclicals dropped 2.5% and the Consumer index lost 1.8%. However, the broad market was less volatile and more resilient than the major averages. The small-cap Russell 2000 was unchanged, while the S&P 400 Midcap dipped only 0.5%. The tech-heavy Nasdaq100 declined 1.5% this past week. The Morgan Stanley High Tech index fell 2.1% and the ever-volatile Semiconductors declined 3.3%. The Street.com Internet index was about unchanged, while the Nasdaq Telecom index declined less than 1%. The Biotechs sold off 2.5%. Sinking bond prices weighed on the financial stocks. The Broker/Dealers were hit for 2.4% and the Banks shed 1.5%. The HUI Gold Bug Index had a rough week, losing 4.4% of its value, as bullion sank $11.20.

The Treasury market was pounded, now having suffered the largest two-week decline since October. For the week, two-year Treasury yields added 19 basis points to 1.35%, while five-year yields rose 18 basis points to 2.45%. The ten-year Treasury note closed the week at a yield of 3.54%, up 23 basis points. The long-bond saw its yield jump 25 basis points to close the week at 4.58%. Benchmark mortgage-backed securities gained some relative performance, with yields increasing 15 basis points. Implied yields on agency futures rose 11 basis points. The spread on Freddie's 4 ½ % 2013 note narrowed about 1.5 to 35, while the spread on Fannie's 4 3/8% 2013 note narrowed less than one to 35. The 10-year dollar swap spread narrowed 2.5 to 34.5. Thus far, tumultuous trading in the Treasury market has caused little grief in the corporate market. Spreads generally narrowed moderately this week, with junk bonds outperforming. The dollar index gained better than 1%, while the CRB index declined over 1%.

Long-term rates shot higher globally. Japanese benchmark 10-year yields increased 13 basis points to 0.725% (up 28 basis points in two weeks!). Australian 10-year yields jumped 22 basis points to 5.03%, while New Zealand yields gained 17 basis points to 5.37%. European yields generally increased 11 to 15 basis points. Hungarian bonds saw yields jump 20 basis points, with Russian Eurobond yields up 15 basis points. Yields were up moderately in Brazil and noticeably in Argentina.

General Motors this week completed the largest ever debt offering by a U.S. company. With bids surpassing $30 billion, GM raised the size of its issuance by about a third to $17.6 billion. The three year GMAC tranche was priced at 290 basis points over Treasuries, the GM 10-year tranche plus 375 basis points, the GM 20-year plus 383 basis points, and the GM 30-year plus 400 basis points. Issuance also included GM EUR 2.5 billion, GM GBP 600 million, and GMAC EUR 3.0 billion. GM also raised the size of their convertible offering to $4 billion. Spreads narrowed after the sale, with the 10-year US$ bonds contracting 20 basis points to 355 and the 30-year US$ bond spread narrowing 14 basis points to 386.

June 26 - Reuters: "This is a wonderful example of the success the Fed can point to in bringing liquidity back in the corporate bond market," said Mitchell Stapley, chief fixed-income officer at Fifth Third Investment Advisors. "It's a sign of less restrictive financial conditions in the economy." "The order books for the various euro tranches of the deal were between 2.5 and four times oversubscribed, said an official at one of the lead managers. He declined to give an absolute level of orders."

Debt issuance remained quite strong, with the higher the yield the better. HSBC Capital Funding raised $1.25 billion, EDS $1.1 billion, Sealed Air $850 million, Caterpillar Financial Services $350 million, Entergy Gulf States $240 million, Fiserv $100 million, and Cytec $200 million. The list of junk issuers seems to lengthen by the week: Reliant Resources $1.1 billion, PG&E $600 million, FPL Energy $380million, Gerdau Ameristeel $405 million, Arrow Electric $350 million, LNR Property $350 million, Worldspan $280 million, Vought Aircraft, Bally Fitness $200 million, GulfTerra Energy $250 million, Merisant $225 million, New World Restaurants $160 million, Mortons Steakhouse $105 million, Huntsman Advanced Material $100 million, Availl $200 million, Digitalnet $125 million, Danka $175 million, Alaris Medical $175 million, Avondale Mills $150 million, and Mobile Mini $150 million. And the list of convertible issuers includes Halliburton at $1 billion, EDS $690 million, Sealed Air $300 million, RF Micro Devices $200 million, Meristar Hospitality $155 million, IMC Global $125 million, McMoRan $100 million, and Nektar Therapeutics $100 million.

June 25 - Dow Jones: "Global bond issuance reached record levels in the first half of this year as borrowers locked in low interest rates and investors flocked to fixed-income assets. International debt capital market volume rose 16% in the first six months of 2003 to a record $2.5 trillion, according to preliminary figures compiled by Dealogic… The rising bond issuance included a 50% rise in global corporate junk bonds to $71.7 billion, the sector's largest volume in five years. Investment-grade bond issuance posted a more subdued 10% gain in the first half to $693.1 billion. Dealogic said the volume of mortgage-backed securities rose 12% to $476.4 billion in the first half of the year."

June 23 - Dow Jones: "U.S. dollar-denominated bond issuance in Asia, excluding Japan, could rise almost 20% from 2002 as issuers move to take advantage of favorable market conditions, Lehman Brothers said Monday. New supply picked up after the war in Iraq, with an estimated $6 billion of issuance in May and June, taking the gross amount in the first half of 2003 to roughly $11 billion. For the whole of 2003, Lehman predicted gross issuance to reach $21 billion, near 1996 levels, and up from $18.2 billion last year, driven by record low rates, tight spreads and declining external risk… Minus redemptions, net issuance is expected to nearly double to $14 billion, from $7.8 billion."

June 24 - Bloomberg: "Romania raised 700 million euros ($810 million) in a sale of Eurobonds as investors build stakes in countries preparing to join the European Union in 2007. The former communist country priced the seven-year bonds to yield 5.975 percent, or 2.6 percentage points more than the mid-swap rate, a benchmark for international borrowing. That compares with 10.63 percent when the government sold debt of the same maturity two years ago. Investors who profited from soaring Polish, Hungarian and Czech bond prices as EU membership was confirmed for 2004 are seeking the same returns in Romania, Bulgaria and Croatia, which are bidding to be among the next wave of member nations… Romania last year received more than 2 billion euros of orders for a sale of 700 million euros of bonds due 2012. The bonds have risen since then, with the yield dropping to 6 percent from 8.8 percent at issue. The yield on Poland's 2012 euro-denominated bonds has dropped to 3.9 percent from 6.3 percent a year ago."

June 26 - Bloomberg (David Evans): "On April 3, J.P. Morgan Chase & Co. held a conference in Manhattan, drawing about a thousand people to discuss one of the fastest-growing and least understandable financial markets in the world: credit derivatives. 'We outgrew the Waldorf and had to go to the Sheraton Towers,' says Andy Brindle, global head of credit derivatives at J.P. Morgan. 'Next year, we'll have to go to Madison Square Garden, I think.' …The global credit derivatives market, which wasn't even tracked until 1997, has ballooned to $2 trillion based on the so-called notional value of the debts that underlie the contracts, according to Fitch…That market, Fitch predicts, will grow to $4.8 trillion by next year. The entire derivatives market -- including transactions based on stocks, bonds, loans, commodities, currencies and mortgages -- has a notional value of about $100 trillion, according to the International Swaps and Derivatives Association. Those numbers are only guesses. Nobody knows how much money is actually at risk. Banks don't have to report the details of their exposure, which leaves regulators in the dark. 'This market is completely unregulated,' says Randall Dodd, director of the Derivatives Study Center, a nonprofit research organization in Washington, and a former economist at the Commodity Futures Trading Commission. 'No reporting requirements, no collateral requirements, no licensing of traders,' Dodd says. 'There's no supervision of this activity. Even if you're a regulator and you want to see what's happening, you can't.'"

The Federal Reserve, of course, cut short-term rates to the lowest level since 1958. It happened to coincide with the announcement of an all-time monthly record for New Home Sales, and the same week that saw the largest ever U.S. corporate debt issuance. For those that missed it, I'll share some of the commentary provided on CNBC from one of our list of outspoken inflationists.

Larry Kudlow: "I don't think the Fed sets interest rates. I think the market will set those rates. But the Fed can purchase two-years, five-years, ten-years. In fact, when you take a look, year-to-date they have actually bought $10 billion of notes… I just want them to add cash. I don't want them to control interest rates. Just add excess reserves to the economy and the banking system and let this recovery really develop."

CNBC's Bill Griffith: "And when the Fed goes out and buys Treasury securities that way, that is what they are doing: they are putting cash into the system.

Kudlow: "That is correct. They buy them and they pay for them literally with reserves that they create out of thin air. And it's kind of a cool system. Too bad you and I can't do it."

Kudlow: "To me I was hoping for more of a shock and awe statement from the Fed. Something that would have suggested they're determined to keep pushing liquidity in. They're determined to move to an excess reserve position. They're determined to finance the economy and the tax cuts that are going to raise demand for liquidity. And they are determined to keep this position for a good long time. To me, they should have been thinking outside the box. This was very much inside the old box and therefore quite boring… What we really got…was a silent prayer. What the Fed really needed was a Hail Mary..."

Central bankers may not directly set long-term interest rates, but I would strongly argue that leveraged speculators keying off of Fed policy have evolved as the market's price-setters. The critical issue is not creating "an excess reserve position," but the Fed's capacity to engender adequate and balanced system liquidity. Yet our system has for some time suffered specifically from excessive, speculative, and wildly unbalanced liquidity. Mr. Kudlow, the Fed several years ago began throwing Hail Marys. They now mindlessly just keep lobbing them, having discarded the tried and true game plan for a hope and a prayer. (And it's working as effectively as it would on the gridiron)

While unimpressive, the economic data seems to demonstrate gradual improvement by the week. Initial jobless claims dropped 22,000 last week (44,000 in three weeks) to 404,000. This was the lowest reading in 13 weeks. Weekly bankruptcy filings were at 31,461, slightly ahead of the year ago level. Year-to-date filings are up 9.3%. University of Michigan Consumer Confidence increased a stronger-than-expected 2.6 points to 89.7. Current Economic Conditions added 2.7 points to 94.7, the strongest reading since April.

May Personal Income was reported up 0.3%. Year-over-year, Personal Income has gained 2.9%, with Wage and Salary up 2.0%. Manufacturing wages were down 2.0% y-o-y, while Service wages gained 3.1%. Government wages jumped 4.7% from a year earlier and Transfer Payments gained 6.4%. With a declining tax burden, Disposable Income was up 3.7% y-o-y. Personal Spending increased 0.1% during May. The unbalanced nature of the economy is again illuminated. Spending on Durables declined 0.7%, while spending on Services increased 0.5%. Year-over-year, Personal Spending was up a respectable 4.6%, with Durables up 5.2% (to $889 billion), Non-durables up 4.3% (to $2.19 Trillion) and Services up 4.6% (to $4.5 Trillion). Personal Spending has surged almost 39% since May 1997.

Broad money supply (M3) rose $19.9 billion last week, with nine-week gains of $168.2 billion (11.4% annualized). Demand and Checkable Deposits jumped $16.0 billion and Savings Deposits gained $15.2 billion. Savings Deposits were up $498 billion, or 20%, to $3.0 Trillion over the past 52 weeks. Last week, Small Denominated Deposits dipped $1.7 billion and Large Denominated Deposits declined $15.5 billion. Retail Money Fund deposits dipped $6.0 billion, while Institutional Money Fund deposits added $5.3 billion. Repurchase Agreements added $8.2 billion, while Eurodollars declined $1.2 billion. Elsewhere, Total Bank Assets declined $52.6 billion, reversing the previous week's $56.6 billion increase. Securities holdings declined by $11.9 billion, while Loans and Leases added $5.1 billion (up $30.4 billion in three weeks). Consumer loans rose $7.6 billion, and Commercial and Industrial loans added $500 million. Atypically, Real Estate loans declined $9.2 billion.

Mortgage insurer PMI Group announced this week that they would not meet Wall Street earnings estimates. The company now believes Expected Claims Payments will be approximately 20% above earlier estimates at a range of $210-$220 million. Also, "The company continues to evaluate the carrying value of its investment in Fairbanks Capital Holding Corporation, which totals approximately $140 million."

From Goldman Sachs' quarterly earnings report: "Fixed Income, Currency and Commodities (FICC) produced net revenues of $1.59 billion, its second best quarter ever… Net revenues in Trading and Principal Investments were $2.01 billion compared to $1.44 billion for the second quarter of 2002 and $2.15 billion for the first quarter of 2003. FICC revenues of $1.59 billion increased 39% compared to the same 2002 period, reflecting higher net revenues across nearly all businesses, particularly credit products, interest rate products, currencies and mortgages. FICC continued to operate in a favorable environment, characterized by tightening credit spreads, declining interest rates, a steep yield curve, volatile currency markets and strong customer demand."

New Home Sales surged 13% during May to a record 1.157 million pace. This was 11% above the consensus estimate. The average price jumped $7,500 to a record $242,500 (up $11,400 over two months). And with New Home volume up 17.9% y-o-y and the average price up 7.1% y-o-y, New Home "Calculated Transaction Volume" (CTV) was up an eye-opening 26.3% y-o-y. For two years, volume was up 31%, prices up 15%, and CTV up 50%. The average price is up 42% from the May 1997's $170,700. And while the Months Supply of New Home inventory sunk to a record low 3.5, the dollar value of this inventory is up 30% in twenty four months (volume up 14% and prices up 15%).

Existing Home Sales were also impressive. Sales were up 7% over two months to a near record level, with the average price up $8,700. Year-over-year, May sales were up 4.4%, with y-t-d sales running 2% above last year's record pace. And with prices up 7.1% y-o-y, Calculated Transaction Volume was up 11.8% y-o-y to an annualized $1.255 Trillion. CTV is up 28% over two years, 38% over three years, and a noteworthy 95% from May 1997. The Midwest saw average prices surge $10,800 over two months (up 14.9% y-o-y), as sales volume jumped almost 11% to a new record. Average (mean) Prices were up (y-o-y) 10.7% in the Northeast, 4.3% in the South, and 3.0% in the West. The Months Supply of Existing Home inventory declined from April's 5.1 to 4.7 months.

While backing off moderately, the Mortgage Bankers Association application index remains at historic levels. The Refi index dipped 10% last week, although it is up 180% from a strong year ago level. Purchase Applications declined 2.8%, but were up 4.6% from the year earlier. In dollar terms, Purchase Applications were up 10.7% from a year ago. The average fixed-rate mortgage loan was $170,600 last week, with the average adjustable rate mortgage at $322,300.

The Florida Association of Realtors reported May sales up 6% y-o-y, with median prices up 8% to $149,900. "In May 1998, the statewide median sales price was $99,800, resulting in a 51.5% increase…" Year-over-year price gains included Daytona Beach's 20%, Panama City's 21%, Miami's 15%, and West Palm Beach-Boca Raton's 14%.

From the Illinois Association of Realtors: "Buyers continued to boost Illinois home sales to new heights in May… The statewide median cost of a resale home in May rose 8.7 percent to reach $172,290; it was $158,500 in May 2002… This May was the strongest May on record since the association began reporting statistics in 1990, and the current pace continues to amaze even the veteran sales agents... The median existing single-family home price in the Chicagoland last month was $225,800, up 9.5 percent from $206,200 in May 2002."

According to the California Association of Realtors, "The median price of an existing, single-family detached home in California during May 2003 was $369,290, a 15.6 percent increase over the revised $319,590 median for may 2002 (up $5,330 for the month and $49,700 y-o-y!)." "But with the median price…posting double-digit increases in 22 out of the past 24 months, affordability concerns are increasing for many families in California" "While we don't anticipate sales to top last year's record level, 2003 looks to be the second best year for residential real estate on record." A Long Beach real estate agent summed it up: "The problem is, is that there's just nothing to sell. Supply and demand is killing us." The most notable price gains continue at the "lower end." Los Angeles enjoyed 19.8% y-o-y price inflation, Central Valley 19.4%, Riverside/San Bernardino 19.4%, Sacramento 17.7% and High Desert 16.9%. Other notable y-o-y gains include Ventura's 25.6%, North Santa Barbara County's 26.5%, and Northern California's 16.1%. The statewide inventory of unsold homes is at 2.3 months, less than half the national average.

The Nelson A. Rockefeller Institute of Government (Nicholas W. Jenny) this week issued its June 2003 report, "State Tax Revenue - Slowing Again". First quarter state revenues increased 1.4% sequentially, an unimpressive gain after 2002's third quarter rise of 2.5% and fourth quarter gain of 1.9% (2002's third quarter gain ended four straight quarters of sequential revenue declines). This year's first-quarter rise of 1.4% compares to the year earlier 7.8% decline. By category, personal income taxes declined 3.1% y-o-y, a notable improvement from first quarter 2002's 14.3% drop. Corporate income taxes were up 10.3% during the first quarter, versus the 16.1% decline the year earlier. Sales tax receipts were up 1.9% during the first quarter, compared to a 1.0% decline during 2002's first quarter. State revenues suffered an average quarterly decline of 3.5% during 2002, with only a 0.5% gain during 2001. This is quite a turnaround from the 6.1% average gain posted during 1996 and 1997. Revenues surged an average 7.6% during 1998, before dipping slightly to 1999's 5.8%. Average quarterly growth surged to 8.1% during the climax of stock market-related revenue gains enjoyed during year-2000 .

The consequences of Credit excess-induced boom-turned-bust are nowhere more problematic than in the tarnished Golden State.

During the five-year period (fiscal years 1995/96 to 1999/00), California revenues surged 68% ($29 billion) to $71.9 billion (according to state data). This financial flow melee culminated with fiscal 1999/00's historic one-year 22.7% surge. On the expenditure side, state politicians (and rapidly rising costs) could hardly keep pace. During the five-year period, total expenditures jumped 58% ($24.5 billion) to $66.5 billion. The number of workers on the state payroll increased by about 20% in four years. Overall spending rose 8.2% during '95/96, 8.1% during '96/97, 7.7% during '97/98, and 9.4% during '98/99. With the torrent of tax receipts and the seduction of New Era banter, expenditures surged 15% during '99/00. Yet the fiscal year ended with a large budget surplus and giddy politicians. And then came fiscal 2000/01. State spending surged 17.4%, but the stock market-induced revenue spigot ran dry. Receipts actually declined almost 1% for the fiscal year; prospective surpluses as far as the eye could see instantly morphed into a deficit black hole. Boom had turned bust, although various makeshift financing mechanism papered over the expanding hole for a couple of years.

Now, with a budget crater of somewhere between $29 billion and $38 billion, state coffers nearly depleted of cash, and lenders increasingly apprehensive, the Golden State is finally approaching The Wall. Yet because the state has been in financial quagmire for some time and has repeatedly averted financial crisis, there is understandable complacency in the media and markets. I would advise against complacency, although the state does appear to have resources to operate through much of the summer. Last week the state's finance director stated, "California is broke. We are operating as of today completely on borrowed money, and we have no collateral left for additional borrowing capacity."

For the past two years, the state has used myriad financial gimmicks (including selling tobacco settlement bonds) to postpone the day of reckoning. But the much anticipated recovery in revenues failed to materialize, while several years of hoping allowed the state's fiscal position to spiral completely out of control (analogous to an unemployed individual that risks ballooning Credit card balances to sustain his lifestyle). Earlier this month (June12), the state issued (with bank support and extra fees) $11 billion of warrants to meet short-term cash requirements. This was the largest-ever issue of such warrants. California now receives the lowest S&P Credit rating of any state, with yields about 40 basis points wider than the bonds issued by fiscally challenged New York and Texas. Last week the state issued 30-year bonds at 5.0% (8.4% tax-adjusted yield), about 64 basis points wider than AAA state credits. This spread was up 14 basis points from April, as virtually every other spread narrowed sharply. A Fitch spokesperson was quoted by Bloomberg: "California can't go on forever living on borrowed money. At some point, the market is going to change its mind" about lending.

June 12 - Sacramento Bee (Alexa H. Bluth): "'We are perilously close to losing the trust of the market,' (state finance director) Peace said. 'This was a sale that was clearly against the credit rating of the banks, not the credit rating of the state.' The warnings came as divisions intensified between Democratic and Republican lawmakers and as a new statewide poll showed little public support for sweeping tax increases. Republican lawmakers - whose votes are needed to meet the two-thirds requirement to approve a budget - said they will not budge from their position against tax hikes… The Democratic governor's budget plan calls for a temporary half-penny sales tax increase to pay off $10.7 billion in proposed deficit bonds, as well as increases to cigarette taxes and income taxes for top earners… Davis defended his budget blueprint, despite the lackluster showing in the poll for many of its components. 'If I have to choose between maintaining our progress in public education, continuing to provide health insurance for children, and continuing to protect you against both crime and terror or raising taxes, I am going to raise taxes,' Davis said."

The governor is now under serious recall risk, while Republican lawmakers are resolute in their pledge to not allow tax increases. The democrats are equally resolved to avoid the draconian program cuts that would be required to get the state's fiscal house in any semblance of order. A recent attempt at a bi-partisan solution collapsed with virtually no support. From Bloomberg: "The plan…would cut 23,000 state jobs (the state has 295,000 workers), raise $6 billion in taxes, and slash $20 billion from state programs." The only Republican that has announced publicly that he would support a tax increase was quoted: "Without bipartisan cooperation, we're heading for a fiscal train wreck. Sadly, there is little hope for change."

Los Angeles Times (Evan Halper and Erika Hayasaki): "During budget crises in previous years - last year's budget was not signed until Sept. 5 - the state has not had to cut off as much money, but this year is different. A California Supreme Court ruling in May gives Westly very little flexibility. That decision came in response to Howard Jarvis Taxpayers Assn. lawsuit to force lawmakers to take the budget deadline seriously. The court said the state has no legal authority to make many payments if no spending plan is in place. The court also ruled that state workers can be paid no more than federal minimum wage until a budget is passed. The ruling gives state finance officials some time to reprogram their payroll system to make that possible. Westly said the computers will be updated by early September and, if no budget is in place by then, all state workers' pay will be cut. 'A no-budget situation is not just academic,' Westly said. 'It will create real problems and hardships. This is going to be real hurtful for the state of California.' Trial courts, child development programs, some mental health services and mandated payments to local governments cannot legally be paid after July 1 until a budget is in place, Westly said. Once the budget is passed, however, all payments will be made retroactively."

More yesterday from the Los Angeles Times: "On Wednesday, State Controller Steve Westly warned that California's cash reserves are drawing down, and banks are refusing to lend the government any more money until it straightens out its budget mess." "Roughly $1.5 billion in state money will stop flowing to schools, colleges, transportation projects and medical providers."

June 26 - Sacramento Bee (Alexa H. Bluth): "If there is no budget after Tuesday, (state Controller) Westly said: California will not make monthly payments beginning in July that total more than $200 million for K-12 schools and $200 million for community colleges. State employees face drastic pay cuts as soon as late August. Vendors will not receive payments for services rendered to the state after July 1. Westly will continue a tradition of withholding pay from elected officials… Westly said he is limited by a recent California Supreme Court ruling that dictates most state workers be paid the federal minimum wage - $5.15 per hour - when the state is running without a budget." Quoting the Chancellor of California Community Colleges: "We're talking about massive shutdowns in access and services that will begin to occur as early as August." Westly was quoted: "This will create enormous hardships for literally thousands of vendors around the state who are absolutely innocent to the gyration of the budget battles of Sacramento."

On the revenue side, car registration fees have been raised sharply. From Bloomberg: "Owners of the 26 million registered automobiles in the state will begin to pay on average $158 more a year starting October 1…" Yet, quoting a Republican lawmaker: "This tax increase is not only a bad idea, it clearly violates the California constitution. I'm convinced that the courts will ultimately force the governor to give all the money back." And so goes the battle…

Los Angeles Times (Dan Weikel): "In a hearing room filled to capacity, customers of Orange County's largest sewer agency Wednesday both praised and criticized a proposal to double their rates over the next five years to help finance a $2.36-billion capital-improvement program… 'Our vehicle license fees have just tripled,' said Paul Durazo of Westminster, who said he has been unemployed for 11 months. 'It seems like everyone is screaming for more money. Why do we keep getting saddled with the bills?'"

It may prove to be months away, but there is an accident unfolding out in California. And while the Golden State is faced with the largest and most pressing fiscal dilemma, it should be clear at this point that the root of the problem is systemic and structural.

Today from the Washington Post (Dale Russakoff): "State governments' financial health, which hit the lowest point since World War II last year, has worsened in the past six months, all but ensuring continuing cuts in priority programs such as education, Medicaid and aid to towns and cities, according to a survey released yesterday by the National Governors Association. Budget cuts and layoffs this year produced the deepest state spending reductions in dollar terms since the governors began their fiscal survey in 1977… Still, with revenue declining more steeply and longer than in the previous two recessions -- and with Medicaid costs rising sharply -- many governors are likely to follow the lead of Maryland's Robert L. Ehrlich Jr. (R), who on Wednesday ordered a spending cut of as much as 10 percent... Medicaid spending - which takes up 20 percent of state budgets - grew 13 percent in 2002, (and) 8 percent this year… 'Medicaid is becoming the Pac-Man of state government, eating up each additional dollar generated in revenue,' (executive director of the governors association) Scheppach said."

The great late-nineties inflation imparted severe distortions. As politicians are bound to do, inflated receipts were immediately spent and extrapolated far into the future. (One of the many reasons it is the crucial role of a prudent, independent central bank to contain excesses!) It is instructive to note that the financial health of our states has actually worsened over the past six months, this despite the Fed's "reflation" "successes". But this should be no surprise. After all, the nature and manifestations of Credit inflation are characteristically altered over time, leaving the Fed powerless to regenerate the "favorable" old buoyant (stock market and option-induced) flow to state coffers. Out in California, ultra-easy system-wide Credit conditions are having minimal impact on state revenues. They are, however, severely inflating the price of housing, with generally rising costs for insurance, medical care, tuition, energy and other utilities. Such inflationary manifestations are anything but conducive to either fiscal balance or economic health.

And while the budget quagmire garners some attention, there is a more momentous development unfolding insidiously. Importantly, the cost of doing business in the Golden State - for businesses as well as state and local government - continues to rise. This is one hell of an intractable structural problem, only aggravated by current monetary policies and dysfunctional Monetary Processes. And there is absolutely no way for the Fed to now even out inflationary effects, with continued rampant Credit inflation only exacerbating terribly distorted price structures and economic maladjustments.

In this regard, California is surely more than a mere microcosm of the general maladjusted U.S. economy, where inflated cost structures find it only more difficult for business to compete globally. With respect to boom and bust dynamics and the great risk of flawed monetary policies, California will prove an historic case study. And while I am no fan of juxtaposing our economy's predicaments with those of Japan (altogether different economic structure and culture), there is one major similarity: conventional inflation measures completely failed to capture the profound increase in the "cost of doing business." And as Japan has learned, this is a key structural problem impervious to even the most extreme monetary and fiscal policy measures. It is also a most important issue disregarded by Mr. Greenspan in his serpentine plan to fight a collapsing stock market Bubble with only greater monetary accommodation. This conundrum of an inflated "cost structure" and substandard growth also provides a good example of why learned European central bankers often expound that monetary policy is an ineffective mechanism for rectify structural problems, although it is quite prone to exacerbate them.

As analysts, we'll follow the goings on in California with keen interest. The state was at the very heart of the late-nineties Bubble, and we are today provided with a case study of how implausible it is to readily (as opposed to requisite arduous adjustment periods) abrogate past inflationary distortions with further inflation. Furthermore, the Golden State remains at the very epicenter of the Fed's continued failed monetary experiment - with only more desperate measures attempting to sustain an unsustainable Bubble. After all, the Great California Real Estate Bubble has about the strongest inflationary bias today of any asset class. And as difficult as things are today, the very serious trouble arrives when this historic Bubble finally succumbs.

I am convinced that a tottering California housing market was one of the key early-nineties factors that incited a panicked Fed's to collapse interest rates (setting in motion the Great Credit Bubble). Ironically, and quite ominously, when the gargantuan Golden State real estate market inevitably falters the Greenspan Federal Reserve will have already frittered away its ammo. The Fed will lack even the sufficient arm strength to dump a little screen pass, let alone muster a last-second Hail Mary from deep in its own endzone.