Wednesday, July 1, 2009

California: Hell-As-IOUs

I was asked to comment on California's budget predicament. The state has just started issuing IOUs to its suppliers - not exactly a reassuring sign for a borrower that still sports an A/A-/A2 rating for its GO bonds from the major rating agencies.

SAN FRANCISCO (Reuters) - California's lawmakers failed to agree on a balanced budget by the start of its new fiscal year on Wednesday morning, clearing the way to suspend payments owed to the state's vendors and local agencies, who instead will get "IOU" notes promising payment.

Just about every financial spin-master I have read places the blame on government inefficiency, gerrymandering, etc. In other words, they say this is politics as usual - if a bit less so given the current depth of the economic crisis. No one seriously considers the possibility of default, assuming the federal government will be forced to bail out the country's most populous and economically important state. After all, if California was a country it would have the eighth largest GDP in the world.

But.. California in NOT a country, it does NOT have its own central bank and it does NOT issue dollars. It issues bonds priced in dollars, which is an entirely different matter. In that, it resembles Argentina back in the 1990s when it hard-pegged its currency to the US dollar, with disastrous results.

What matters, then, is how the real economy is doing in California. Two charts:
  • For the three major metro areas in CA, home prices are off 43% from the top reached three years ago. Home prices are crucial because local governments derive a big part of their revenue from real estate taxes.
CA Home Prices Off 43% From The Top
(Data: S&P)
  • Unemployment is soaring in California. It just touched 11.5% in May, the highest rate in at least 33 years. Payroll and income taxes are collapsing.
Unemployment in CA Soars To 33-Year High
Chart: FRB St. Louis

Quite obviously, then, the budget crisis in California is fundamental in nature; it's not a party-politics stand-off to score points with the voters. It won't be easily fixed in a (non-smoking, surely) back room where deals are cut and backs are slapped. This is REAL and is happening in real-time.

Default probability? Certainly a whole lot higher than the A/A-/A2 ratings would suggest.

  • Addition: It is instructive to consider facts with all political baloney stripped away. California's general fund revenues are around $100 billion and are derived as follows: 50% personal income tax, 35% sales tax, 10% corporate income tax (see table below, click to enlarge).
Source: CA Governor's 2009-10 Budget

The current budget deficit is projected at $26.5 billion, i.e. 26.5% of revenue. No further discussion necessary..


  1. Rating agencies that could be corrupt and incompetent? This matrix keeps getting weirder and weirderer.

  2. I love the "no smoking" room bit. And the comparison to Argentina.
    Well, from the other side of the Atlantic, it sure looks like we're all in this together...
    Employment isn't looking too promising over here either, as I have been saying for quite some time now.
    Somebody laughed at me the last time I spoke about structural adjustment from the IMF...
    American imperialism is deflating like a hot air balloon these days, isn't it ?

  3. Cali's dilemma . I've always thought Prop 13 was generational warfare. Basically, if you owned a house in CA before 1978 you're entitled to one of the greatest tax loopholes known to man. You can also sell the place you owned in 1978 and transfer your golden tax status to your new place. You can also give the property to relatives and they can keep the golden tax status. Its ridiculous.

  4. It occurs to me that one of the best ways for citizens of CA to finally slash bloated government and egregious inflated-weighted pensions, is for vendors to simply refuse to accept CA's illegal tender and insist on payment in real money. If refused, they need to resort to normal legal process to enforce payment.

    It is a once in a lifetime opportunity for the people to be finally heard and their wishes acted upon.

  5. H:

    Thanks for responding and posting on the California crisis. I was going to point out Prop. 13, but Dink beat me to it.

    A couple of other factors that I think affect government funding (or lack thereof) and spending: one is that state law requires at least a two-thirds majority of legislators or popular vote for any tax increase. Yet, at the same time, popular vote referendums can impose government spending to further social policy from the ballot box (a kind of "unfunded mandate").

    The public pensions can be a problem, and public employees -- not just in California, either -- may find themselves in the same position as private employees, namely, without a pension to speak of.

    I was asked this very question by Charles Hugh Smith back in early 2007.

    Some of you may have read it before. If so, I apologize; but I saw this problem coming a long way off. (I know, we all did.)

    The conservatives have said that the problem is "too much spending." But I have not heard them propose spending cuts on anything but social services and public education. And, the state of California has been selling state parks to try to raise some cash.

    Does "eating the seed corn" mean anything to anyone?

  6. 1. Illegal Mexicans

    2. Prop 13

    3. School Administrators & Union (not teachers) - 90% of CA's school budget goes to administration - only 10% gets into the class room, you could easily cut 80% of the school budget and increase teacher pay with the rest.

  7. Yes California is a 3 tier state,
    1. those that grew up here prior to 1978,

    2. those that tried to move here and are all now leaving, taking jobs with them.

    3. illegal Mexicans

  8. What if the market really takes care of prop 13 by pushing prices all the way to 1978 levels.

    That would be something.

    We already back at 1998 in some markets, 2001-2003 prices in others.

    A CA default could get us back to 1980 house prices as overpaid public employees default on mortgages (as they should)

  9. Ha Ha, waiting for the public employees to post out "high cost of living in CA" and thier "right" to thus get subsidized by the government.

    CA subsidizes public employees and illegal Mexicans - soon there will be no private employement left - why would I subsidized 2 classes of criminals with my hard earned money?

    I can come visit CA on vacation easy enough.

  10. The latest California budget crisis will be solved the way the previous crises were "solved":

    Some token items will be cut from the budget; more politically sensitive items will be pushed off-budget.

    Some state property will be sold and fees raised; revenue assumptions will be revised to reflect an even more insane over-optimism.

    This will enable the can to be kicked down the road and the day of reckoning delayed for a few more months until the next crisis.

    Anything else would be - Communism!

  11. But What do I Know?July 2, 2009 at 4:10 PM

    So let me understand this--CA can't or won't exchange IOU's paying interest for dollars to pay for goods and services so they are issuing IOU's paying no interest for goods and services. This is a fascinating opportunity to study the reaction to the IOU issue. Do they start trading at a discount? If so, where and when? Who will be the first to start discounting? Will Gresham's Law still hold in this day of electronic money?

  12. OT:

    Sorry, I just read something that I think should qualify as the "Outrage of the Day."

    NY Bar denies bar applicant who passes bar exam entry because he has student loans

    A clip:

    In January, the committee of New York lawyers that reviews applications for admission to the bar interviewed Mr. Bowman, studied his history and the debt he had amassed, and called his persistence remarkable. It recommended his approval.

    But a group of five state appellate judges decided this spring that his student loans were too big and his efforts to repay them too meager for him to be a lawyer.

  13. With the 8th largest GDP in the world it is too bad CA cannot be its own bank.

    I seem to recall where one state has a national bank, I think Dakota, and it is in great shape.

    Joe M.

  14. Joe's got a point there.
    It makes me wonder how long the Union is going to hold up...
    Okie, I left you two comments on your blog.

  15. But What do I Know?July 2, 2009 at 9:20 PM

    Oops, I guess they are going to pay interest on the IOU's--so it's more like forcing their suppliers and employees to accept bonds for payment--it still will be interesting to see if Gresham's Law will apply--CA is essentially selling bonds to unwilling buyers as opposed to willing ones. . .

  16. Issuing IOUs instead of paying cash reminds me of the Ottoman empire in its dying days. Ït too resorted to paper money (IOUs) instead of paying its bills in money of the day (gold and silver).

    After a few weeks the paper was essentially worthless, accepted only at very large discounts to face value.

    Arnold the Sultan?

  17. Well, Hell, I have just come back from four days in Albion, and since the European experience often entailed (in the past...) dealing with different (paper) currencies (much more so than in the U.S. where you can EVEN have your passport REFUSED as an official piece of identity LOL), I couldn't get over the impression that those PAPER notes were just like Monopoly money.
    I used to think that I was a loony, but now I'm pretty sure that I'm just more AWARE and HONEST than most others...
    That paper money (in IOU form, or in OTHER forms) looks pretty WORTHLESS when it is being spit out of ALL THOSE ATM MACHINES.
    Why hasn't anyone imagined that the phenomenon of RARITY could ALSO apply to that consummate symbol, FIAT CURRENCY ?
    The plastic has brought down the paper...

  18. Just raise taxes. CA people are paying way too low taxes.

    The total tax (100 billion) is about three times that of Finland. Finland has 5 million inhabitants, CA has 7 times more.

    Or: if no more taxes, become a 3rd world country with no services provided by the state.

  19. Say Hells, you didn't mention home / property taxes in the mix? I thought they made up a big portion of revenue. Are they included in the personal income tax figure? Thanks.

  20. RE taxes go to local govt. i.e. cities, towns, etc., not the State.

  21. I left California last year. Best move I ever made.

    You can always visit if you miss the illegal Taco stands.

  22. Argentian issued IOUs when they went broke.

    The IMF (US Empire Government) decided not to bailed them out and so hyperinflation resulted.

    I agree we sell Souther California to Mexico and take the rest of Mexico's oil, then bankrupt Southern California and cut off the water supply from the north - within 2 years they will be most poor state in Mexico.

  23. Sarah Palin quit because she could not handle running Alaska - check the news - completely incompentent.

    She when from running a one horse town to the state.

    Thank God you religious retards did not elected her int the white house.

    OMG. What a nightmare that would have been.

  24. One of the problems with Prop 13 is that the lower taxes also apply to commercial property. Unfortunately, as long as the property belongs to the same corporation, the taxes will never really increase.

    I often wonder if California wouldn't do better if it were its own country. We'd get to save all of our federal taxes instead of shipping them off to Washington and getting pennies back.