TW: California is barreling towards its July 1 fiscal deadline without resolution. This should be interesting. California is a partial metaphor for the rest of the nation's fiscal situation. This piece's core point- "The [CA] public imagined that they could have world class government services with extraordinarily low levels of taxation" is applicable to the balance of the nation.
The California situation frames numerous issues:
1) Fiscally speaking Californians mouths are bigger than their stomach's and their system is good at feeding the mouth without digesting properly. The governance structure in CA can relatively easily initiate new spending programs (via referendums) but cannot raise the commensurate taxes (need 2/3 majorities for that and the state districts are gerrymandered to elect strident partisans from both sides).
2) CA creates systematic risk for the rest of the country. If CA were to default on its bond obligations, we would be talking about another cascading financial crisis as other muni bonds across the nation would come under new scrutiny (rates would rise etc.). A CA default is highly unlikely as I believe the bondholders are ahead of just about every stakeholder in CA but for education. In other words CA would have to stop paying firemen, police, health care expenses first before defaulting on the bond payments.
3) CA symbolizes the challenge of variable revenues amidst a demand contraction. As CA (or any other state) contracts is spending in line with its contracting tax revenues, it feeds the downward cycle of overall demand. States unlike the Federal government do not have the leeway to deficit spend to counter the overall demand contraction.
4) But for the federal government to "bailout" CA creates a major moral hazard. If states think Washington will ultimately bail them out then their incentives to address their own problems is greatly diminished.
5) Would the rest of the country support "bailing out" CA?
For these last two reasons, I do not believe Obama will "bail out" CA. The political support issue is important but should ultimately be secondary. The moral hazard issue should be paramount. There are ways for that issue to be overcome (i.e. by CA initiating governance reforms to prevent the deficit from recurring) but the only way those reforms will happen will be through a game of chicken with the federal government. While I support playing the game, these games are how disasters occur and depressions are created. Things should never get to this point.
From Economist:
"...NPR interviewed two mayors from California cities—San Diego and Santa Anna—on the subject of the state's budget crisis and the state government's efforts to close the yawning gap between revenues and expenditures by taking or borrowing money from metropolitan budgets. The mayors were obviously not very pleased with this approach, but what surprised me was how sanguine they seemed about the crisis in general, and how unable they were to discuss the actual issues involved. The mayors appeared to believe that so long as their local budgets were sound, no amount of state level cuts would much affect them. They also stood firmly in the belief that California voters were entirely in the right in placing strict constitutional limits on tax increases, and they declared that the "literally bloated bureaucracy" needed to live within its means.
It's all well and good to talk about a bloated bureaucracy, but state legislators could cut government employment in Sacramento to the bone without making much of a dent in the budget crisis. It isn't the pencil pushers spending the money, it's the demands of the public, expressed through their elected representatives but also directly, in statewide ballot initiatives.
The public has imagined that they could have world class government services with extraordinarily low levels of taxation. This is a fantasy, and one is sorely tempted to let the state figure this out for itself. Presumably, after the sudden release of thousands of prison inmates has spurred a spike in crime, drastic cuts to top universities generate mass academic brain drain, and shortfalls in key social services lead to a wave of well-publicised suffering, Californians will begin to get the picture—you get what you pay for.
For now, the administration seems inclined to take this approach...presidential advisors have determined that California is not yet at the brink and ought to work harder to close its budget gap by itself. Obama officials are also nervous that a California bail-out will lead to a wave of requests from other states
...Structural budget problems in California and elsewhere are a major roadblock, and no aid should be forthcoming until binding negotiations have taken place between state and federal officials, establishing a path to long-run budget stability. But this is the wrong place to hold a line against bail-outs.
For one thing, countercyclical aid to states is entirely appropriate. Most state constitutions prevent their governments from running annual budget deficits. This means that in recessions, pro-cyclical tax increases and service cuts are necessary. There should be a federal aid automatic stabiliser in place to prevent this (accompanied by a "tax" on state budgets during boom times).
...But it is also clear to me that this is the next Lehman. This is the domino you can't let topple. There are no good options available. A default would roil municipal debt markets and could seriously harm both state budgets and financial markets. Solving the budget crisis without addressing the constituional issues would involve pro-cyclical and economically destabilising budget cuts. Solving the crisis while addressing the constitutional limits on tax increases would prevent dangerous cuts to services, but would still be pro-cyclical, and is at any rate impossible in the necessary time frame.
The downsides to intervention are clear—moral hazard, growing demands from other states, the risk that California may not fix the underlying issues, the use of scarce political capital to obtain funds from Congress, and so on. But the adminstration has gone to great lengths to put a floor under this economy, guaranteeing that no major financial institutions would fail and racking up a trillion dollar deficit. Letting California go would throw much of that work out the window. How one observes the failure of a middling investment bank creating global financial havoc and then allows the world's eighth largest economy to crater over a matter of $24 billion is beyond me. I remain convinced that the adminstration will not allow it to happen"
http://www.economist.com/blogs/freeexchange/2009/06/slipping_into_the_sea.cfm
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