California

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Italy on the Brink

By now you know the news: Italian bond prices have climbed to levels only recently reserved for the likes of Ireland, Portugal, and Greece. A catastrophe is on the horizon.

We need not dwell on the details because the situation is too fluid. The Italians have postponed remedial action for way too long, and the supposedly solid core nations – particularly the Germans – are steadfastly refusing to take the necessary steps to avoid disaster.

In my opinion the only viable solution is a combination of aggressive expansion and growth oriented policies in Germany and the other “corer” nations; a much weaker Euro; and simultaneous austerity and competitive adjustment in the so-called peripheral nations like Portugal and now Italy. Any other option – and there are a few being kicked around – are temporary and will lead to an inevitable break up of the single currency. At present I am not sure the Euro will survive anyway.

The Italians, like the other peripheral nations have plunged into a fundamentally unsound uncompetitive relationship with the core nations, especially Germany. This is untenable. Under non-Euro circumstances the remedy is clear: a devaluation of the domestic currency, possibly an arranged default, and subsequent growth. Within the strictures of a single currency a devaluation is not possible, so the adjustment comes in the form of an enforced deflation – or internal rather than external devaluation – which is both pronounced and pernicious. A nasty recession lasting years is almost inevitable within any country taking such action.

Italian growth is simply too low, and interest rates now too high, for its debt to be reduced through “normal” policies. We have entered crisis and urgent response territory.

Some of you have asked why the situation in California has not precipitated a similar default circumstance here. California after all has managed its way to a fiscal ruin very similar to Italy’s. The reason is simple: California falls under centralized federal fiscal policy, which can thus mask the shock. Plus cross border flows of jobs, workers, etc are more easily accomplished in the US. So California’s adjustment, while it is going on, is just one part of a more integrated whole, whereas those of the likes of Greece or Italy are much less smooth because there is no single fiscal policy umbrella, and those other movements are more difficult. So the tensions build up more dramatically in the case of the Euro Zone than they ever do here.

If the Euro Zone cannot find a way to manage this next round of crisis it will implode. The reverberation from a collapse would have nasty knock on effects for global trade and US banking. It may well push us into a recession.

So pay attention. And let’s all hope the Europeans change their ways and act decisively for a change

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Californiastan?

I haven’t poked fun at California lately, but how can I pass this up?

Bloomberg and Reuters now reports that the cost of credit insurance on California debt is now higher than that of such rock solid, fiscally sure places as … Kazakhstan, Lebanon, and Uruguay.

Ouch!

All the media attention being focused on the mess the Greeks have made of their economy, and it is an enormous mess, misses the point. The Greek economy is small compared with California’s. Very small. A Greek debt default would not shatter the world economy, but a California implosion could. Remember: California is the world’s eighth largest economy, and its $20 billion a year deficit is destroying its ability to raise cash to meet its obligations. Actually that’s not quite accurate: what is hurting most is the fact that the state seemingly has no intention of fixing its problems, or ability to to get its political gridlock settled so responsibility can be placed squarely on anyone. Calofornia has become the poster child for the way in which hard and fast constitutional limits can scupper sensible or responsive politics. The people voted for the series of disasters that have led to California’s slide, so they have to shoulder the blame.

As for Greece: I learned today that Greek bureaucrats get not twelve monthly paychecks, but fourteen. They get an extra monthly check twice a year. Plus the Greek retirement age is 61 – way below the EU average. No wonder the place has a budget crisis. It’s laughable.

But for California credit risk to be more expensive than Kazakhstan … that’s just insane.

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Kick The Greeks Out?

A small majority of German voters apparently now want to kick the Greeks out of the Euro. That won’t happen, of course, due to the enormous consequences of exposing the Greek economy and its new non-Euro currency to the fury of the world markets. Going solo right now would be a one way ticket to oblivion.

I have not yet commented at all about the big mess that has surfaced in Europe, but since it seems to get top billing in the financial media it’s worth taking a look at. In particular we need to compare the crises in various Euro countries with the very similar crises in various US states.

In many ways the problems faced by California, Florida, and New Jersey – to name the obvious suspects – are very similar to the crisis that is currently engulfing Greece, Portugal and Ireland. Notice I leave Spain off of this list, an omission I will explain in a moment. Each of these countries or states has run profligate and reckless budgets in the recent past, the consequences of which are now coming due. The easiest example to lampoon is Greece, where the government has run massive deficits, the tax system is so corrupt that revenues are never collected, and the nation is knee deep in over-paid and under-worked civil servants. There is nothing positive to say about the way in which the Greeks ran their economy over the last decade or so. They are due for a nasty and brutal adjustment.

In some ways the Greek problems are a classic example of what we call ‘the tragedy of the commons’. This is a circumstance where a group of individuals – such as a nation – make decisions that collectively impose a cost on society, of which they are a member. In many ways this is the diametric opposite to Adam Smith’s fabled ‘invisible hand’ where individual greed produces a collectively superior and beneficial result.

The example in Greece is non-payment of taxes. The Greeks, like the Italians, are culturally so averse to payment of taxes that it is normal for them to keep two sets of books: one for cash and one for all other payments. Naturally cash payments go unreported for tax purposes. The size of this cash, market is so large a piece of the entire economy that it significantly alters the tax rates necessary to levy on the taxable part in order to raise sufficient revenues to pay for the Greek equivalent of Social Security and so on. It gets worse: because tax rates are so high, many people evade paying them, which just makes the revenue shortfall worse.

None of this would matter were it not for the fact that the people who are avoiding and evading taxes still want to receive their state pensions. That plunges the state into debt. A fiscal crisis soon follows, and unemployment rises rapidly. In other words the culture of cheating simply boomerangs and damages those who cheat as well as those who don’t.

That’s a simple case of a ‘tregedy of the commons’.

The comparison between the Euro and the US states like California breaks down at a macro-economic level. The two situations provide valuable lessons in economics.

Let’s go back and look at Spain.

The Spanish economy was run in exemplary fashion. It had very conservative fiscal policies and tight management all around. The Spanish, however, are cursed with glorious weather, so in the real estate boom times of the last decade cash flooded into Spain from other European countries, in particular Germany. So far the analogy with Florida is fairly good, but the analogy with California and New Jersey has already broken down due to their profligate budgeting and fiddling of expenses. The Spanish experience gets unique after the bursting of the real estate bubble. Prices had been driven up by that flood of incoming cash, so after the bubble broke Spain found itself hopelessly uncompetitive. Its labor market was overpriced, and it was left as an outlier in terms of prices, and productivity.

The big divergence between the Euro and US state experience is now exposed: whereas the failed US states still benefitted from massive inflows of Federal cash in the form of Social Security, Medicare, and other program payments, Spain is self contained at the fiscal policy level. That means it receives no fiscal aid from some source outside itself, there are no ongoing payments to provide stimulus. Worse: Euro monetary policy is centralized. This means that Spain’s interest rate and currency exchange rates are outside its control. The combination of having no control over its currency and yet no sources of fiscal aid, reduces Spanish options to virtually nil. The entire burden of getting their local economy going falls on the Spanish budget. Consequently they have to institute extremely harsh measures to stop the rot. Spanish unemployment has shot up to near 20%, they are experiencing severe deflation, and there is no real prospect of a near term recovery. Had Spain not ben part of the Euro it could simply have devalued its currency and allowed a much softer adjustment to take place. Instead is is stuck in a rigidly and externally imposed currency regime.

Contrast that with Florida. There the process of adjustment is much easier: its local real estate and labor markets are linked more freely with the general US economy. Stimulus cash flows in easily and monetary policy is a non-issue. Florida, although it suffered a bigger bubble will adjust more quickly because other parts of the US are sending cash in via the Federal budget – Florida doesn’t have to slash its own budget as much as a result.

This is the big lesson to take away from the Euro crisis. The euro experiment was half baked. Monetary policy was unified, but each country kept its own fiscal policy. That has now been shown to be a foolish mistake. There are two solutions: ditch the Euro or unify national budgets into one Pan-Euro fiscal policy.

I have already mentioned that I don’t think the Euro will be ditched. The economic consequences for laggards like Greece, Portugal and Ireland would be devastating. The political consequences would be equally incalculable. So I expect the Euro area to fudge and muddle its way through the crisis. The cost will be massive in terms of slow economic growth and high unemployment, but both will probably be better than the alternative. Oddly though I see the long run being very different: eventually this crisis will provide impetus to tighter fiscal union. The Euro experiment has gone too far down the road to turn back, so logically it must plunge on forwards. I doubt there will be any greater union in the next few years, but such a union is now almost inevitable.

So it is very dangerous to compare the crisis in the Euro region with the crises unfolding at the state level here. Decrepit US states like California and Florida can survive because they they are not independent and are subsumed into Federal monetary and fiscal policies. They are bailed out through the backdoor rather than through the front door.

Poor Spain has to suffer despite having done everything correctly because it has no control over monetary and currency policies. That throws the burden onto its local fiscal policy which has to be draconian because it is the only lever available locally.

As for Greece: they deserve what they get. Fortunately they are so small in terms of the entire Euro economy that their failure should not prove too disruptive. I expect them to suffer through regular crises and wild swings from growth to collapse until they establish a more modern economic infrastructure to support the level of expenditure they seem to demand of their government.

You have to pay taxes if you want the government to give you a pension and health care.

Hmmm. What an interesting concept!

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California Bashing

I haven’t taken a swipe at the third world nation known as California for a while. So here goes.

It pains me to read that the state’s college system is contemplating raising undergraduate fees by as much as 32%. Even with this increase the in-state tuition bill will only hit $10,000 which is not outrageous in this day and age of egregious education expenses.

The harm this will do to the state’s businesses I can only imagine. The flow of college graduates from what was once one of the world’s top college systems will surely be severely reduced. The cost is staggering: there are currently over 1,500 academic jobs unfilled due top lack of money. Classes are being cut. Professors laid off. Building plans and research eliminated. The system may never recover.

Importantly the people hit most hard will be the kids from poor households, many of whom are finding the current low level of tuition hard to pay. So at some point in the future California, because it cannot get its head around a sane property tax system, will be faced with having to import talent to keep its vaunted high technology sector alive. That may not be a problem: a steady flow of graduates will always be attracted to California’s climate and beaches. But it makes the state dependent on other parts of the country and, possibly, even more dependent upon a flow of foreign graduates.

The damage being done is insidious and may be hidden from the average taxpayer view. Many may not even care. Eventually though the state’s standard of living will fail to keep up: a weak education system is a sure indicator of a nation, or state, in decline.

We have just witnessed Obama being treated with a certain contempt in Asia – not just China – because American decline is now becoming evident. Our rapacious borrowing and complete disdain for investment in infrastructure – physical and intellectual – will assuredly accelerate the pace at which Asian economies overtake ours. It is not possible to imagine the Chinese slashing education investment. The Chinese seem to understand that cause and effect of investment in knowledge. It is the very bedrock of prosperity.

We evidently don’t get that.

We persist in the beggar thy neighbor attitude towards taxation that has produced the debacle in California. Unwilling to pay for anything long term we seem to expect others to supply an endless stream of stuff to fill the gaps we don’t want to pay for ourselves.

We already rely on imported talent. The gap is only going to get worse.

That gap will be compounded by the social stratification we are building in: most Americans have no clue that social mobility – here we call it the American Dream – is greater in most other industrial countries than it is here. A child born into a poor American family has less chance of reaching middle class status than a similar child most anywhere in Asia or Europe – even in those horrible neo-socialist Nordic countries like Sweden. By making education harder to come by California is reinforcing the stasis here. Poor kids will find it harder to get ahead. America will build a class structure based upon access to education. It will become rigid and riddled with divisive social and political issues. It will become old.

We have trashed the American Dream in the space of two generations. Greed and a total lack of community are the cause.

That’s shortsighted and dangerous.

It’s also a damn shame.

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Nationalize California!

I ended my post on Friday last week with a tongue in cheek question: should we nationalize California? Given the turmoil that has erupted since the announcement of a budget compromise this morning, nationalization may now be a serious option.

“California is a true banana republic – it would be laughable were it not for the tragedy about to unfold.”

California has managed itself to the edge of oblivion, and like GM or Chrysler it deserves no sympathy at all from the rest of us. It has a convoluted and seriously damaged legislative system riddled through with anachronistic nonsense like the perverse ‘proposition’ process that allows any rich group of people to band together and collect enough support to pass legally binding single issue proposals. These propositions are a deep rooted part of the current malaise: they contort the budget process and prevent any form of holistic management of problems. They are an activists dream, but a managers curse.

Similarly the state’s constitution is plainly out of date with its insistence on super majority votes for tax increases.

These two ridiculous governance antiques, plus the states deeply divided voter base, have produced a level of incompetence that has now reached comic proportions.California is a true banana republic – it would be laughable were it not for the tragedy about to unfold.

Because the proposition system has blocked property tax revenue increases – it worse than that: it has generated a huge diversion of tax burden away from the wealthy and onto the poor – California relies disproportionately on income taxes for the bulk of its revenue. naturally in a time of job loss and wage cuts that implies a big fall in state income.

At the same time other propositions allocate money to things like education.

So the budgetary room for maneuver is minimal.

Throw in an electoral system rigged to ensure re-election of incumbents of both parties, and it is surprising that the state has not imploded before. There is no incentive for elected officials to be responsive to voters: they are generally assured re-election. So personal advancement comes from adopting ever more extreme partisan positions. The result is that the state’s legislature is populated by politicians on both sides of the aisle who have a near kamikaze desire to be seen as inflexible: there are no-tax absolutists, and no-spending cut absolutists, but precious few people trying to solve problems.

The place is a joke. And it is an exemplar of how not to construct a democracy. It is ‘me-ism’ run amok. No wonder it sent us Ronald Reagan: the ultimate ‘me-ist’.

Now the chickens come home to roost.

With revenues collapsed, no ability to raise revenues because of the ‘no-tax’ folks, and an unwillingness to trim spending because of the ‘no-cut’ folks, the state’s budget has spiraled out of control for months.

Today’s ‘compromise’ is a resounding defeat for the people of California: services will be slashed, tens of thousands of jobs will be lost, and the state’s debt will rise sharply. The school system is about to be thrown back decades. And the poor will suffer the loss of many basic safety net programs.

In other words this is a victory for the Hooverites.

So: the state’s recession is about to deepen. Those lost jobs are lost revenues for local business. The damaged schools system suggests an impaired competitive position down the road. Lost jobs also means lost tax revenues: thus adding to the very problem the job cuts are designed to solve. And the new borrowing adds to the state’s future tax bill.

Examples of the carnage: 20,000 teachers fired; there will be no music teaching, no art, and no physical education funded. Low income children, about 930,000 of them, will have their benefits cut. Cities and other municipalities will lose about $4.7 billion in state funding – so they will have to cut also. And $1.3 billion will be cut from low income health care generally. And oil drilling off the coast of Santa Barbara is to be given the go-ahead.

Quite what oil drilling will do to solve a near term crisis I don’t know, but it looks as if the right wingers won this one hands down. Their property taxes won’t go up, so those pockets of wealthy citizens are safe, and they’ve just assured a good supply of low educated cheap labor to mow their lawns in the future.

It makes me cringe to think that an economy as wealthy as California’s: it is huge by international standards can be so poorly managed.

Nonetheless that’s where the state now is.

Unable to pay its debts because its citizens presumably don’t care about either the quality of life or their fellow citizens enough to figure out a better way of government.

As I said: were this GM the credit markets and the world at large would be walking smartly away from the place. It would be on its knees begging for assistance. We would be discussing a bail-out and the terms to attach to it.

And the shame is this: because California is such a large part of the US it’s cutbacks are likely to make our recession harder to throw off. Those extreme moves the state is taking are Hooverite – they are exactly opposite to what is needed. The federal stimulus will be blunted by the idiocy at the state level.

So: should we just nationalize the place, write a check to balance its budget, and then enforce management and constitutional changes to make sure it doesn’t screw up again? That’s what we did to GM. Why not California?

Addendum, Tuesday, 10:45 p.m.:

Here’s the New York Times on the California debacle. The end of the California dream? Perhaps. Most of the so-called sun states live an illusion. They are full of people who want services for low cost. It is the state equivalent of a ponzi scheme: the only way they get away with it is constant growth to generate extra revenues, not from setting the taxes high enough to pay for things, but by getting more people in. Of course, like all ponzi schemes, when the music stops something has to give. All the sun states will have to confront this issue sometime: the need for infrastructure clashes with the population’s ‘dream’ of something for nothing. Then reality sets in and disillusionment follows.

Addendum 2:

This review in Washington Monthly of a book by Kevin Starr captures the sense of decline well. No one can eliminate the possibility that California can recover. It will. But the scars will also be deep and that fizz that made the state so compelling for thirty to forty years has clearly gone. Now it’s more like a brooding adolescent: petulant, confused, and totally lacking innocence. Too bad, but they all grow up sometime.

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