California's Day of Reckoning: May 19

by Gary North
by Gary North

"Hasta la vista." ~ Terminator 2

On May 19, Californians will go to the polls to decide the fate of six propositions. These propositions all deal with the tax code. Passage of all five of them is required to ratify the compromise that was hammered out by Governor Schwarzenegger and the legislature. That compromise was facilitated by the vote of one Republican, who switched sides after weeks of deadlock. A two-thirds vote is required by law in each house. Three Republicans in each house voted for it – the bare necessity. The last man to switch was Abel Maldonado, a businessman.

The compromise mandates $14 billion in tax hikes. Some compromise!

The state is facing a deficit of $42 billion. That is not the total budget. That is the deficit. One nonpartisan website summarizes:

The California state budget, according to Governor Arnold Schwarzenegger on January 16, is in a "state of crisis." He said that the $42 billion deficit the state faces "is a rock upon our chest and we cannot breathe until we get it off." As recently as October 2008, the state was projecting a much smaller deficit in the range of $8 billion. Even with the smaller deficit the state was marked as a state "that couldn't pay for itself" by BusinessWeek for having the highest percentage budget gap in America, with 22 percent.

If any of the five fail, the budget package must go back to the legislature. The fiscal year begins on July 1. There is not much time to come up with a solution.

The polls indicate that five of the six will fail. Only one is assured of passage. That one specifies that if the state runs a deficit, there will be no pay raises for legislators in that fiscal year. That proposition is on the ballot only because the vote-switching Republican made it a condition of his vote to raise taxes. Their pay is $116,000 a year, plus $170 a day for expenses. Frozen? The horror!

The governor has been on the road across the state promoting yes votes on these propositions. Yet, back in 1990, he sat in front of the cameras and did a promotional for Milton Friedman's PBS TV series, "Free to Choose." His rhetoric was libertarian. You can view his promotional on YouTube.

Decades ago, my friend M. Stanton Evans came up with a law, comparable to Murphy's Law. I came across it in a delightful compilation of these laws, a book titled "The Official Rules." It is designated as Evans' Law of Political Perfidy. "When our friends are elected, they aren't our friends any more."

Anyone who imagines that electing someone governor in a high-tax welfare state like California is going to make a difference is suffering from political delusion. The governor could have killed this monstrosity with a veto. Instead, he is campaigning for it.

His public opinion rating is down to 33%. That makes him a winner. The legislature's favorable rating is at 14% (Field Poll). Critics are likely to vote no on the Big 5.

Within days, it will be panic time in Sacramento. The governor and the legislature will have to come up with another compromise. The last one almost did not materialize.

Republicans are in a position to kill this spending monstrosity. Their votes can keep the two-thirds majority from occurring.

If California adheres to the state constitution, a no vote on May 19 will de-rail the state's finances. The state will have to survive with whatever revenues the existing tax code will generate. The recession is cutting revenues rapidly and across the board.

Then the credit-rating agencies will go to work. There is a high probability that California's credit rating will be lowered within a few weeks. This will also take down the bonds of municipalities, for cities that depend on state funding.

If California's credit rating falls, the state will have to pay more interest to generate lenders who will buy its bonds. But who wants to lend to a state whose legislature is paralyzed and whose governor cannot persuade voters to agree to a budget deal? What likelihood is there that California will go bankrupt within a few months? Unless the Federal government bails out the state, the likelihood of bankruptcy is high.

This is why I think Nancy Pelosi (D-San Francisco) will attempt to push a bailout bill through the House of Representatives when California's voters turn down the budget. If she is successful, then a new precedent is set. The U.S. government becomes the lender of last resort to state governments that are faced with a taxpayer revolt.

That will mean that all American taxpayers will be 6n the hook. The lender of last resort is the taxpayer, who must fund the Federal government.

BONDS AND PRICE INFLATION

There are high-income Americans who invest in municipal bonds. They don't have to pay Federal taxes on income from these bonds. This is a Federal subsidy to municipal debt. But municipal bonds rest on the ability of cities to generate sufficient revenues to pay off the bonds.

It should be clear by now that the bankruptcy of California will raise doubts about the solvency of the muni bond market. The Federal government will be pressured to use revenues from national taxpayers to subsidize bonds that exempt their holders from taxation. Talk about a redistribution of wealth!

The endless subsidies of the current tax system are so numerous and so complex that no one can sort them out. The system rests on the assumption that municipalities will not go bankrupt. But they can.

The ultimate guarantor of state bonds would then be the Federal government by way of the Federal Reserve System. This means monetary inflation: funding the Federal government. But price inflation raises long-term interest rates (bonds), which lowers the market value of existing bonds.

The economy is dependent on the Federal Reserve System to fund any shortfall in the Federal government that results when private investors and foreign central banks fail to buy Treasury debt. That raises the issue of the long-term viability of the bond market.

A TAX REVOLT HAS BEGUN

California's crisis will escalate on May 20. It will be clear to everyone that there is a tax revolt in progress. Californians have this wonderful advantage: they must approve every tax hike. The state constitution mandates this. This means that they can veto the spending plans of state politicians. This threatens the unions.

The trade union movement is on its last legs in the United States. The collapse of the Big Three auto manufacturers has put the United Auto Workers on the defensive. The UAW pension fund now owns 55% of Chrysler. That means it owns 55% of a turkey. Industrial unions are barely visible today.

Unions still have large memberships in government bureaucracies. The teachers' union is the largest in the country. But a budgetary crisis in California points to what is coming nationally. Taxpayers are going to revolt. The revolt has begun.

California is a high-tax, high-spending state. It is now facing the end result of a political system that believes that the state can always collect more money from the public. The public is about to issue a veto.

The amazing fact is that mainstream media pundits see this veto as a big mistake on the part of voters. Somehow, voters do not perceive that higher taxes are a good thing. They are going to vote down tax hikes that are needed to fund "vital services."

The pundits cannot come to grips with the concept of vital services purchased by taxpayers with their after-tax income. The pundits are ready to accept a $14 billion tax hike, despite the fact that this will reduce the number of vital services that taxpaying citizens can afford to purchase for themselves. For the pundits, vital services are those services supplied by the state, which has either a monopoly over the supply of these services or else provides subsidies for them.

The threat of a tax revolt to the union movement is very great. If union members can no longer extract wealth by way of the ballot box – "yes" on debt and taxes – then they will face either unemployment or wage cuts. They will lose their competitive advantage, which rests on their ability to force government agencies to deal with them. The agencies are not allowed to hire non-union workers.

I did a Google search for the following:

vital services
California
May 19, 2009

Here are the hits. You can click on some links. See how many lead to sites run by state employees, unions, local governments, and Democratic Party politicians.

California leads the nation in trends, both good and bad. This is one of the good ones. Politicians around the nation will be aware of the outcome of this election. They will see that they cannot rely on taxpayers to foot the bill for every pork-laden budget.

The economy is in recession. The tax base is falling. Revenues are falling. State expenditures are rising because of unemployment insurance expenses. When the voters get through with five of the six propositions, California's yes-vote legislators will find that their yes votes not only did them no good, they exposed the state's government to a crisis. They will have to pay for "vital services" with revenues generated in a recession.

The state's deficit will move up like a rocket. There will be no way to raise added money through taxes. The state will have to borrow. It will find that it must pay much higher interest to secure the loans.

All eyes will turn to Washington and Mrs. Pelosi. Like Mecca to Muslims is Washington to state politicians. Politicians do not bow in prayer facing Washington five times a day, but they surely make phone calls to Congressmen and Senators.

The faster the dominoes fall at the state level, the more pressure there will be on Washington to run a larger deficit. Politicians cannot bring themselves to live within a budget. They see vital services – and vital votes – on all sides. They refuse to cut vital services. They always hope for another deferral of the day of reckoning.

Politicians believe in something for nothing. Washington is going to be asked to supply lots and lots of something for nothing. California's politicians want to be able to go before their constituents and assure them that vital services will still be available at below-market prices. Uncle Sugar has come up with the money.

THE BOTTOMLESS PIT

Politicians believe in the bottomless pit of tax revenues. They are like investors who think the same thing about corporate bailouts. Washington is seen by all as a bottomless pit of wealth to fund vital services. All services are vital, although some are more vital than others. Which are the most vital ones? Those that are supplied by union members. Unions vote as blocs.

The bottomless pit is the taxpayer. He is called on to fork over the money. But he is now using a knife rather than a fork. In California, voters have knives. They will use them on May 19.

The Federal Reserve System is the bottomless pit during recessions. It will soon face a new source of demand: state governments that cannot balance their budgets or sell their bonds.

If the Federal government bails out California's government in order to overcome a veto by voters, then voters can forget about reining in state governments. They can veto spending, but they will wind up paying for Federal bailouts of busted state governments.

If Congress does not hold the line in this issue, the precedent will be set in concrete. Governors from now on will say: "You bailed out Arnold. Why not bail out me?"

The political centralization process will escalate. When the Federal government is seen as the escape hatch for state government spenders, it will pay to spend, run up a huge deficit, and threaten to default.

California voters will send Sacramento a message on May 19. The question will then be this: What message will Congress send to state legislatures around the nation?

CONCLUSION

I suggest that you pay attention to the results of the special election of May 19. Be prepared to see a bailout of the state government by Congress. Here are the political questions that will face Congress on May 20.

If AIG is too big to fail, what about California's government?

If Chrysler is entitled to almost $8 billion in Federal funding just to go bankrupt, how much should Congress pay to keep California from going bankrupt?

I expect an emergency bailout package to be signed, sealed, and delivered within weeks. The faster the bond market responds, the faster Congress will act.

Let us see whose budget gets cut: California's or ours. Probably ours.

May 16, 2009

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2009 Gary North

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