TCS Daily


Financial Sunset in the West

By Adam Paul - July 2, 2009 12:00 AM

Late last year, Joel Kotkin a fellow at Chapman University, warned about a political and economic sundown in California. With a failed vote on the state's budget, sunset seems to be quickly approaching. The state passed a budget in February but has been battered by the economic crisis and has lost about 20 percent of expected tax revenue since, in large part because much of the state's employment was in the real estate sector. Today, California will begin issuing IOUs to creditors.

California is both the largest state economy, accounting for almost 13 percent of US GDP, and one of the most financially mismanaged. The state faces a $24 billion budget deficit. Yet the state legislature and Governor Schwarzenegger have been unable to agree on a budget. Thus the state begins its fiscal year with no cash on hand and must begin issuing IOUS. In a release, California's Controller, John Chiang, who would issues IOUs, said ""Next Wednesday we start a fiscal year with a massively unbalanced spending plan and a cash shortfall not seen since the Great Depression."

The need to issue short-term debt could hardly come at a worse time. The large budget deficits will likely require cutting spending and tax increases, a situation that an LA Times interactive budget planner makes clear will involve difficult choices. Standard and Poor's cut the state's credit score in February, giving it the lowest rating of any state, which could make creditors less likely to accept promises rather than cash. The LA Times reported on Wednesday that only one financial institution, Golden 1 Credit Union, has publicly discussed plans to accept warrants; a spokesperson for the Controller's Office explained that no institution has formally agreed to honor the warrants.

The initial IOUs, likely around $3.5 billion, could be followed by more debt issuance to balance the budget. The Governor's Budget indicates that up to $5.5 billion in revenue anticipation, issuing bills or warrants that borrow against next year's tax revenue, could be used to help balance the budget. The budget description accurately describes these instruments, "Registered warrants are essentially short-term IOUs." Other budget proposals include cuts in education and law enforcement spending, new gasoline, cigarette, and income taxes, as well as proposals to cut contributions to state employee pension plans--a move that would likely be challenged in court.

Beginning today, California is slated to issue IOUs for short-term debt. This includes about $3.5 billion in payments for government contracts, welfare payments, etc. This type of transaction is not outside the realm of normal business operations. Business activity is often financed through short-term debt obtained in places like the commercial paper market; in that case firms issue paper with promises to repay much like IOUs. The difference is that firms use the commercial paper market when they face liquidity problems not an overall lack of funds. For instance a builder may expect a big payout upon completion of a development project in a few months but need the money to pay employees today. If a development contract, or a state budget, collapses, then the paper has nothing to be redeemed against.

Yet even if California pays its short-term commitments with IOUs it still faces the $24 billion deficit, and the state is looking at impractical ways to solve it. One solution is simply to borrow more.

The problems of California, large deficits, unfunded pension liabilities, and a grinding political process should give pause to our national financial situation. Even after the spike in spending to solve the current crisis passes, Obama's first budget predicts a ratio of federal spending to GDP not seen since WWII. Standard & Poor's, the same agency that downgraded California's debt, has said that the national financial outlook could force it to remove the much-prized AAA-rating from US government debt by 2017, a move that will make it more expense for the government to borrow. California has seen that last-minute fixes are susceptible to failure; the national government should begin seriously addressing its finances now, while there's still some sunlight left.


Adam Paul is a Research Assistant at The American Enterprise Institute.
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20 Comments

This is becoming embarrassing; earlier it’s a few typos, now entire sentences are being repeated
From paragraph 4 :-


“The Governor's Budget indicates that up to $5.5 billion in revenue anticipation issuing bills or warrant that borrow against next year's tax revenue could be used to help balance the budget. The budget description accurately describes these instruments, "Registered warrants are essentially short-term IOUs." Other budget proposals include cuts in education and law enforcement spending, new gasoline, cigarette, and income taxes, as well as proposals to cut contributions to state employee pension plans"


From paragraph 6 :-


“The Governor's Budget indicates that up to $5.5 billion in revenue anticipation issuing bills or warrant that borrow against next year's tax revenue could be used to help balance the budget. The budget description accurately describes these instruments, "Registered warrants are essentially short-term IOUs." Other budget proposals include cuts in education and law enforcement spending, new gasoline, cigarette, and income taxes, as well as proposals to cut contributions to state employee pension plans”

Error fixed
Thanks for bringing this to our attention. Please rest assured that this was a technical error in the posting process, rather than a simple matter of proofreading.

Well connected still get paid in CASH
Some special groups are still being paid in Cash. Got to love the creeping tyranny of large government.

People who get California IOUs:

Grants to aged, blind or disabled persons
People needing temporary assistance for basic family needs
People in drug prevention, treatment, and recovery services
Persons with developmental disablities
People in mental health treatment
Small Business Vendors

People California pays in cash:

University of California
Public Employees’ Retirement System
Legislators, legislative employees, and appointees
Judges
Department of Corrections

Wasting oil
"A recent study by University of California at Santa Barbara professors Bruce Luyendyk, Ira Leifer and J. R. Boles estimates that natural seepage amounts to 10,000 gallons of oil and 3.5 million cubic feet of natural gas a day (enough for 14,000 homes). That means about every three years there is the equivalent of a natural Exxon Valdez spill plus the natural emission of hundreds of millions of cubic feet of methane, a global warming gas much more powerful than CO2. The solution to stop this natural seepage is drilling and energy recovery to relieve the pressure under these underground fissures where the seepage occurs, which would have the additional benefit of reducing our dependence on foreign oil.

Since the 1969 oil spill accident in the Santa Barbara Channel, more than one billion barrels of oil have been recovered through drilling, while the total of spills amounts to just 853 barrels in the same 40-year period or about the equivalent of four days worth of Mother Nature's oil seepage within the channel.'

http://online.wsj.com/article/SB121781568328109027.html

Pumping oil and gas from Santa Barbara will reduce seepage and actually clean up the beach. Of course, there could be those 'environmentalists' who may claim that since oil has been seeping for thousands of years, man must not stop it, but I doubt it.

How are these IOU's different from bonds.
California can't issue bonds without the approval of the voters. How is it that they can issue these IOU's?

Who gets paid what is fixed by law.
On the other hand, look at who wrote the laws.

Honeymoon is over?
"Colin Powell, one of President Obama's most prominent Republican supporters, expressed concern Friday that the president's ambitious blitz of costly initiatives may be enlarging the size of government and the federal debt too much. "

http://www.washingtontimes.com/news/2009/jul/03/powell-airs-doubts-on-obama-agenda/

"Helen Thomas Challenge Gibbs On "Controlled" Town Hall Meeting"

http://www.realclearpolitics.com/video/2009/07/01/cbs_helen_thomas_challenge_gibbs_on_controlled_town_hall_meeting.html

Who edits this stuff...and why does your author not proof-read his own text...
"publicily" Spell-checker would have caught this.

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"The Governor's Budget indicates that up to $5.5 billion in revenue anticipation issuing bills or warrant that borrow against next year's tax revenue could be used to help balance the budget."

The phrase "revenue anticipation issuing bills or warrant that borrow" needs to be redrafted, of course, but the word "warrent" should be pluralized in any case.

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"For instance a builder may expect a big payout upon completion of a development project in a few months but need to money to pay employees today."

"but need to money" should read "but needs the money"

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"California has soon that last-minute fixes are susceptible to failure"

Should read "California has seen that last..."

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Try harder. Do better. There is no reason to be sloppy like this. This is the big time.


Socialism...
Not only are these not bonds to be issued and sold in the open market...they are also not legal tender as defined. They are pretty much "post-dated" checks that would constitute bank fraud if you or I did this.

Furthermore, they are being forced on vendors and employees by the state in an authoritaritarian manner as if the government has a legitimate option to act this way.

Pay us in casino chips, forchrisake. At least we know the Mafia is good for the money.

That's right...
The same people who can't draft a budget.

Democracy has failed us again. It is not just the Palestinians and the Iranians who get a terrible government when they go out to vote. California is right there too.

No way
The honeymoon won't be over until we're all wearing uniforms and singing rousing worker's hymns to The One's great and eternal reign. At that point, our supine news media might snap out of their knob-polishing worship of the Obamessiah and note that a fundamental change to the American way of life seems to have occurred.

One nation...one government...many players...but only one underlying reality...
Robert,

All of this is happening too fast for the government to be confused. They know what they are doing. They are trying to confuse us.

Supply Side capitalism is toast. When we recover we will have a 1% average GDP economy just like the Japanese have been enjoying since 1992...until we figure something better out. We do have some bright ideas about that.

This financial meltdown was far more severe than the government let on and they needed to throw money at the banks in a great hurry to hold up the global economy long enough for it to catch its breath. Then they needed to act like they were willing to continue throwing trillions of dollars at the economy indefinitely so the underlying markets would stop behaving like we are all going to die.

Here we are only a few months later, they are admitting that this thing is much worse than they said by saying it is far worse than they thought and already someone outside the government who we trust...Colin Powell...is urging Obama's reality on us to see how we will react...that we don't actually have enough money to spend trillions and trillions on a stimulous plan and that it wouldn't work anyway.

Joe Biden is sitting on the other side saying "sure it will" but the fact is that the American people need to get used to the idea that our GDP is not going to ever get back to 4% expansion...we haven't been doing that number sustainably since 1970 anyway...but we will recover to something very different now...something more like Japan's economy.

They could not say that on September 15th when they felt like they had to let Lehman Brothers fail really badly...and they cannot quite say that now. But it hasn't been a year yet and they should know what is going on well enough to avoid any further stupidity.

Obama needs to get himself reelected and he doesn't want to get himself impeached. So he could not nationalize the banks or make them roll over GM's debt. But GM had this coming anyway and it was time to pull the plug on those arrogant morons in Detroit.

Once they have us fully prepared for the truth then someone on Fox will quietly tell us what everyone at the White House already knows. Because that's how they do things. They do what must be done and then they let the opposition pound away at us until we understand that things are not really what they seem to be. Or what they told us. Again.

Simple
Issuing bonds requires approval and jumping through the hoops of state or federal regulators, who have to approve the issuance of securities.

Call them "IOUS" and magically its not a bond, funny how government seeks exemptions from the things it insists on imposing on the citizenry.

Political Judgment lacking in Powell.
He was great when he got to give orders and rely on the martial ethic; outside of that his judgment is sorely lacking. He embraced Obama for what reason? Race or getting even with the GOP for not giving him total control as SOS.

Too little to late; perhaps he can do the honorable thing and start pitching Viagra, ala Bob Dole and otherwise shut up.

funny how they violate the Constitution, too
States are forbidden from issuing 'bills of credit', which is what the IOUs are supposed to be used for (institutions and people are supposed to accept them in lieu of cash).

The Supreme Court has ruled on this and it is a fine line. I'd say California is crossing it.

Rubbish!
"Supply Side capitalism is toast. When we recover we will have a 1% average GDP economy just like the Japanese have been enjoying since 1992...until we figure something better out. We do have some bright ideas about that."

Shows what little you know for that Wharton School education.

Japan has had 1% average GDP because it has abandoned the supply side economics it practiced from the 1950s to the 1970s.

You didn't know that, did you? That post-war Japan is a textbook model of successfully implemented supply side economic policies every much as it was because of Deming's industrial theories or even their high savings rates? So was Germany after Ludwig Erhardt's reforms.

The Germans practiced supply side tax cuts while the Japanese did the same but by expanding deductions instead of trimming rates.

Zyndryl's Prayer for Non-Californians
Thank you, O' Lord for the Blessings from out-of-state we are about to receive.

For we Californians are unworthy, but politically powerful -- especially when the Governator and State Legislature play chicken with the Democrats in Congress and the White House with the lives of poor and disabled whom said Democrats depend on for votes.

So therefore, O' Lord, we humbly give Thanks for the Great California Bailout. Or, as Bart Simpson would say it: "Rub a Dub, Dub! Thanks for the Grub!"

Supply Side...
After the Japanese agreed by signing the 1985 Plaza Accord to let the yen float and strengthen...their export economy tanked. Their prices for their products suddenly rose just as a number other players...notably the Koreans...were entering their global markets with very good stuff. And the growth rate for the Japanese fell off. It was going to happen anyway. The Plaza Accord was only the trigger.

The Japanese government creating inflation after 1986 in a purely Keynesian monetary policy attempt to stimulate their economy. But this resulted in a speculative inflationary bubble...especially with real estate...that collapsed into deflation in 1989. From that point until 1992 the government undertook massive fiscal stimulus spending programs...also very Keynesian...and that too failed. Thereafter and until now the Japanese economy has endured a deflationary stasis...expanding their GDP at an average annual pace of only 1%. In spite of their continued wealth and their best efforts. We are right there looking at the same thing ourselves.

Keynesian theory was very much about somewhat higher inflation caused by investments into manufacturing capacity correlated with growth in a rapidly expanding, robust economy. One way we know that the Keynesian economy in the US transitioned into something very different after 1970 was the reversal of the NAIRU (Non-Accelerating Inflation Rate of Unemployment) phenomena. Also Keynes had his inflation/growth causal relationships reversed. Increasing inflation artificially was probably always a dangerous idea.

The Supply Side mechanisms that have dominated our economy since 1982 are extremely sensitive to inflation because higher bank interest rates reduce the ROI on leveraged industrial investments...just as higher corporate taxes on earnings are multiplied for companies with lots of leverage...when those earnings are accumulated into after tax ROE numbers. This describes American Supply Side multinational players.

US Keynesian GDP growth averaged 4.5% from 1929-1949 and again the number was 4.5% from 1950-1969. Staglation was 2.3% from 1970-1982. Take all the noise of the Great Depression, World War II, reconstruction and the Arms Race away and that's what the numbers were. The Kenyesian GDP did 4.5%. Supply Side did 3.1% from 1983-2008 broken into 3.6% from 1983-2000 and 2.1% from 2001-2008. That's all there is. Any way you read it the numbers are the numbers. Through thick and thin Keynesian mechanisms delivered more rapid growth than Supply Side and when both of them slowed down to a 2% rate then our economy was ready to transition. We are at exactly that point in history right now. If we don't move forward then we will join Japan at 1% growth after we recover from this current mess. For certain.

Blame Obama or Bush if you like but it is the underlying economy itself. Blame Reagan or Clinton. LBJ...Roosevelt. Does not matter. The government is not large enough to make our economy do anything. The government can only mess the economy up. Ask the Russians and the Chinese if that statement is not true.

Japan went straight from its keiretsu dominated Keynesian phase through a brief period of Stagflation from 1991-1992 and immediately into its deflationary stasis. There was no Japanese Supply Side economic period at all. The Japanese never dominated the development of the global economy with its own markets the way we did from 1982-2007. And now we don't either...anymore. And we won't ever again. Supply Side is toast. And there is no going back to Keynesian for us. We need to go forward to something better.

There may have been government policies in any civilization all the way back to the beginning of the Iron Age...1300 BC...that you might want to look at and say that those were "supply side" policies such as tax reductions, for example. But this does not mean those nations had Supply Side economies. They didn't. It just means that they lowered their taxes.

"Sometimes a cigar is just a cigar"...(Sigmund Freud)

I sincerely hope this helps. And this material will be on the final. So you might want to look it over again.

Warrants...
Apparently California's IOU's are legal warrants. Imagine that they thought about this hard enough to make certain they were doing something legal...even if egregious.

CA thought it leagal to tax those who don't live in CA, too.
That was found to be illegal.
Governments can get away with anything as long as no one complains.

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