The First Rule of Holes
California is quickly learning the first rule of holes: when you find yourself at the bottom of one, stop digging.
Banks, insurance companies, and pension funds buy government bonds because they are a very safe investment. Suppose they have to choose between the bonds of:
a) Mexico. The world's newest narco-state, so beloved by its citizens that they are fleeing north in record numbers.
b) Kazakhstan, the country made famous by Sacha Baron Cohen's outrageous satire, Borat ("our main form of entertainment is the running of the Jew").
c) California, home to Silicon Valley and Hollywood. The place where the future begins. 37 million people and the world's eighth largest economy.
Trick question, of course. Mexico and Kazakhstan are the safer bets. California, like a lot of state governments, is not only in over its head — we have fallen into a deep hole and responded by digging deeper.
How do we know? Well, you can buy insurance against the risk that a government whose bonds you own will default and not pay you back. Investors buy and sell credit default swaps to insure against this risk (the same contracts which, when untraded and used to bet on the likelihood that convoluted synthetic mortgage derivatives would default, contributed in big way to the demise of AIG and Bear Stearns, a story told elsewhere). The CDS market for sovereign risk reveals the market's view of the odds that a country or a state within the US will go bankrupt. Currently the government in the world considered most likely to default is Hugo Chavez's Venezuela, with 49% odds, followed by Argentina, Greece, Pakistan, Ukraine, Dubai, and the state of California. Investors judge Iraq to be a slight safer bet than the Golden State. Mexico and Kazakhstan are much safer bets.
How can this be? California, a $1.85 trillion economy, has borrowed $85 billion — about 4.5% of the state's GDP. Kazakhstan, a $133 billion economy, has borrowed $100 billion. Are the markets crazy? Should we all sell overpriced California credit default swaps and make some real money? California government officials seem to think so.
Markets might be wrong of course, but we might want to look a little deeper. As Spencer Jakab of the FT reports, Kazakhstan is sitting on the world's 11th largest oil reserves. It grew by more than 8 per cent annually from 2002 through 2007 and runs a nearly balanced budget. Unemployment is 6.7%, they maintain a rainy day fund equal to almost 20% of GDP and they manage their own currency. California, by contrast, has a jobless rate of 12.4% per cent and sent me my tax refund as an IOU last year. California does not manage its own currency, so when it raises taxes or trashes the public infrastructure, people relocate to states that are better managed.
Still, debt of 4.5% of state GDP doesn't seem like that big of a hole. Or is it? The problem that spooks investors turns out to be the obligations that California has not recorded — especially pension obligations. This is a huge problem and not just for California. According to the Pew Center for the States, America's states have collectively failed to fund a trillion dollars of pension obligations. This is if you believe the state's own math. If you rely on private sector actuarial assumptions, you get even bigger numbers. A former administrator of the Social Security system, Andrew Biggs, calculated that with private sector accounting, the states would be short $3.5 trillion. To which you can add another trillion for unfunded health benefits. When puffy conservative white guys on TV go red in the face about exploding debt, this is what they are ranting about.
California's core problem is governance and creditworthiness, not wealth. That any state should have credit issues is from one viewpoint bizarre, since state bonds are tax deductible, meaning that California's borrowing costs are incredibly low, since the federal government provides a nontrivial subsidy.
Is California the next Greek tragedy? So far, finance officials have dealt with the hole with a combination of deferral and denial. Deferral is understandable — if the economy improves and tax receipts rebound, the state can reduce its borrowing. But deferral represents a tiny part of the solution and the politically easy part. Mostly California has been in denial. We have denied the true cost of pension and health care promises made to retirees. We have refused to do math in public because if we did, it would be clear that we will never honor those commitments. California's public employee unions make the math politically challenging to confront. Without them, this problem would be far more manageable because health and pension benefits would be lower.
But the rush to pile all of the blame on unions alone is misplaced: every labor contract has two signatures on it. The problem is that both public managers and organized labor responded perfectly to the incentives that we gave them. Managers continually increased union pension and health benefits because, unlike wage costs, long term retiree costs were not in their budget. Indeed, they were not even costs — they were future obligations often recorded off the books. And when the cost of future benefits was calculated, it was often minimized by a generous assumption about retirement age here and a favorable guess about interest rates there. Soon the costs don't look so bad. Managers promised to deliver tomorrow what they could not afford to pay for today (and frankly, they were out bargained. Not only did public employee benefits skyrocket, wages did as well).
Everybody was happy until tomorrow finally arrived. Now California is very likely to elect a governor who promises to cut the budget and reduce retiree benefits. Unions will revolt. Taxes will increase in a state that already features very high tax rates and mediocre public services. The cable shouters will have their day. And large numbers of people will choose to create opportunities elsewhere. Californians have learned from earthquakes how to dig out and rebuild on solid footing. Our first step is to stop digging a deeper hole.
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