Power to the Patients

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 publicily discussed plans to accept warrants; a spokesperson for the Controller's Office explained that no institution has formally agreed to honor the warrants.

The problems of California, large deficits, unfunded pension liabilities, and a grinding political process should give pause to our national financial situation.

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 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--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 to 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 soon 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 AEI.

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