Repair California’s Fiscal Problems Ourselves – or the Capital Markets Will

Repair California’s Fiscal Problems Ourselves – or the Capital Markets Will

Events in Washington, D.C. have overshadowed the ongoing fiscal calamity in Sacramento, where earlier this month state legislators basically rejected the governor’s reforms almost as soon as they were released. Despite the uncertainty shrouding the capital, the budget crisis will be solved – one way or another.

This certainty is grounded in the reality that, contrary to what some lawmakers assume, capital markets are not limitless sources of finance for profligate governments. At some point capital markets start to slow the flow of funds to government by acknowledging the increased risk of big spending, debt-ridden governments. Increased risk is accompanied by higher interest rates and interest payments. Governments that fail to take corrective action when facing such risks can soon find themselves in what economists call a debt spiral.

The first step in corrective action is to recognize that the state is facing a structural, rather than a cyclical deficit. A cyclical deficit is one that is caused by economic slowdown (i.e. recession) that self-corrects when the economy begins to grow again. A structural deficit occurs when spending is permanently out of line with revenues. That is what California faces and why the state faces a deficit regardless of economic conditions.

The state’s non-partisan Legislative Analyst’s Office (LAO) released an analysis of the state budget late in 2009. It predicted deficits of $20.7 billion this coming fiscal year (2010-11), $21.3 billion next year, $23 billion in 2012-13, and slightly lower deficits in the following two years. Deficits persist even though the LAO predicts a fairly healthy economic recovery, which is optimistic.

For example, the LAO assumes real GDP growth to average almost 3 percent over the next five years. It further assumes a marked decline in unemployment to 7.3 percent (12.3 percent currently) and housing permits to almost double between now and 2015. So the state faces sizeable deficits even when the economy is expected to recover, but does that mean the state is on the verge of entering a vicious, self-perpetuating debt spiral?

That condition begins with a structural deficit – spending more than is available from revenues. The borrowing necessary to finance this overspending brings along interest costs. These added costs drive a wedge between the revenues collected by the state and the amount of money available for actual program spending. Total spending increases to accommodate existing program spending plus interest costs, which worsens the deficit. The higher deficits mean yet more borrowing, which leads to yet more interest costs.

Along the way lenders begin to notice the accumulation of debt and demand higher interest payments to accommodate them for the added risk. This means even higher interest costs, which means even less resources available for a given set of resources. The spiral is now self reinforcing – more spending leads to more borrowing, which leads to more debt and higher and increasing interest costs, which leads to more borrowing, and the cycle begins anew.

In many ways California has already entered this cycle. For instance, according to the U.S. Census Bureau’s annual survey of state government finances, interest costs as a percent of revenues has nearly doubled since 2000. Put differently, nominal interest costs in California have more than doubled from $2.6 billion in 2000 to $5.7 billion in 2008.

Some may argue that California is too big an economy for lenders to worry about risk. Such people would be ignoring the fact that California’s debt is already the most risky (lowest bond rating) of any state. Indeed, Standard and Poor recently reduced the state’s bond rating once again.

If the deficits predicted by the LAO over the next few years come to fruition, capital markets could refuse to provide funds, or the costs of such capital (interest rate) could become prohibitive. Such circumstances would force reforms on the state in a crisis environment.

The choice for California is not whether to reform. The choice is whether legislators will enact meaningful reforms in a thoughtful, proactive way, or whether reforms will be imposed on us from the outside, probably in the not-so-distant future.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.