Californias government soon could be paying its bills with IOUs, Controller John Chang announced this week. And a new report found that Californians personal income dropped 2.5 percent in 2009, the first decline since World War II.
Meanwhile, the state budget still hasnt been passed, despite a June 15 requirement in California Constitution. The governor and Legislature remain gridlocked. And the projected deficit for the state budget, for the year that began July 1 assuming a budget gets passed eventually is $19 billion.
Is it time for Thinking About the Unthinkable as the title of a famous book once put it? Although in this case its not nuclear bomb policy, but what could be called a Nuclear Option on state debt that is, defaulting on that debt.
The states debt currently stands at $68.8 billion, according to Treasurer Bill Lockyers Web site. The cost to service the debt is $5.5 billion in fiscal 2010–11, H.D. Palmer told me; hes the deputy director for external affairs at Gov. Arnold Schwarzeneggers Department of Finance.
Last December, the possibility of default was brought up by Bill Watkins, an economist at California Lutheran University in Thousand Oaks. He wrote on his blog:
In my opinion, California is now more likely to default than it is to not default. It is not a certainty, but it is a possibility that is increasingly likely .
Already, weve seen California officials surprised with the interest rates they have had to pay. What happens if no one buys Californias debt? We saw last September  what happens when lenders refuse to lend to large creditors.
That statement immediately was repudiated by Lockyer:
After paying for education, the General Fund has tens of billions of dollars left to pay debt service. Even at historically high levels, debt service does not come remotely close to needing all the funds left over after schools get paid.
However, as I wrote in an April article for CalWatchDog.com, a 2009 report by Lockyers own department noted that total yearly debt service payments would rise to $11.09 billion by fiscal 2014–15, almost double the current amount, just four years away; and to $19.64 billion by fiscal 2027–08.
What if a governor, to sharply reduce an endemic $20 billion deficit, refuses to pay the loans? For perspective, I talked to Joseph Salerno, who teaches economics at Pace University in New York and is a senior fellow of the Mises Institute, a think tank in Auburn, Ala. He has studied and written about government debt and possible repudiation, for example on Argentina.
First of all, you wouldnt get any more loans, he said of the state government. That would be good discipline. You would have to sell off assets to fund current programs. You could bundle up a lot of the assets and just sell all of them off. The state could make deals with creditors.
Something similar is happening in Greece, which is selling some of its islands to avoid defaulting on its loans. But in April, Schwarzenegger announced that previous plans to sell some state assets would not include an extensive sale of state-owned buildings. A debt repudiation could force such sales.
Salerno continued that debt repudiation would reduce the burden on taxpayers to cover the interest payments, saving, as noted, debt payments of $5.5 billion a year now, and even more in the future. It would improve the business climate in the state because government would be smaller.
Another benefit, he said, is that the state would not be able to fund expensive projects such as the California High-Speed Rail, being paid for by a $10 billion bond voters approved in November 2008, just as the economy was imploding. Today, its unlikely such a bond would pass. The rail also has been criticized as a boondoggle.
Indeed, the governor and the Legislature just voted to pull from the November 2010 ballot a bond measure of a similar amount, $11 billion for state water projects. According to Ballotopedia, the measure was postponed to November 2012. The debt cost of this measure, as well as of the train, would be about $800 billion to the general fund.
Pay as you go
Instead of debt, Salerno urged that pay as you go is good for every state. A good example is New Jersey, where new Gov. Chris Christie turned out to really take the whole thing seriously.
Elected in January, Christie faced a budget deficit of $11 billion in a population of 8.7 million. The equivalent, adjusting for Californias 37 million population, would be about a $44 billion deficit, more than double the current amount. Christie immediately declared a fiscal emergency, slashing spending and even suspending $3 billion in pension payments.
Salerno pointed out that Christie also refused to borrow his way out of the crisis, with one exception: a $267 million loan from the federal government for education. If that money had been refused, President Obama would have given it anyway directly to the school districts of his Democratic opponents.
Have the austerities to the state government brought disaster to New Jersey? Nothing has happened to the rest of us, said Salerno, a New Jersey native.
Schwarzenegger has been unwilling to make such serious efforts to fend off a default. And gubernatorial candidates Jerry Brown and Meg Whitman, although issuing plans to deal with the states deficit, have not proposed taking things as far as Christie.
A default would force their hands, Salerno said. It would force the state to go back to the basics of protecting the people and their property and operating a court system. Stop the payoffs to cronies and their constituents.
Dropping the big one
California should immediately repudiate the state debt, Lew Rockwell told me; hes president of the Mises Institute. Either you repudiate it, or make people who arent part of the deal pay for it. That would make it virtually impossible for California to borrow for a long time. Thats too bad for the investor in the bonds. But investing is a risk. Why should the bond holders have to force their neighbors to pay for it through tax collections?
He pointed out that debt repudiation by a state is nothing new. The last one was by Arkansas in 1933, during the darkest days of the Great Depression the worst economic calamity before the current one. And according to the Globalist, after the Panic of 1837:
Nine U.S. states (of the 26 that had joined the United States by this time) ended up defaulting on their debts. Four repudiated all or part of their debts and three went through substantial renegotiations.
Two of the defaulting states Maryland and Pennsylvania were able to resume debt payments, with back interest, as soon as a property tax was enacted. The other defaulting states, however, already had high property taxes. Without access to new revenue sources, these states were forced to default, and then either renegotiate or repudiate their debts.
In the wake of this crisis, states began to enact laws that forced fiscal restraint on their governments, initially to limit state guarantees of private borrowing.
California, of course, already is one of the most heavily taxed states in the country. And a record tax increase of $13 billion in 2009 failed to end the deficit problem. So that option probably isnt available. But perhaps restoring the Gann Limit on state spending is a possibility.
The states bond rating is the lowest of the 50 states, and just four notches above junk-bond status, meaning it already pays a premium on its debt.
Meanwhile, the governors May Revise budget projections expect economic growth to continue, so the states tax base can expand and pay the debt. But the past week has seen increasingly gloomy national economic news:
- The federal deficit rose $165 billion in just one month.
- The stock market dropped 250 points on August 11 as investors continued to lose confidence in the strength of the global economy in the wake of the Federal Reserves dimmer outlook and a decline in Chinas domestic economy.
- Bloomberg analyst Laurence Kotlikoff wrote, Lets get real. The U.S. is bankrupt.
* Jobless claims rose to the their highest level since January.
In these circumstances, Rockwell brought up the now mostly extinct tradition of a family holding a mortgage-burning party. For California, he urged, Gov. Schwarzenegger, burn the debt.
Reprinted from the CalWatchDog.