Should We Let California Go Bankrupt?

A New York Times story about the budget deal that California legislators struck last week to close the state's monstrous deficit noted that, "California is an example of what you will see across the country" as state budgets come under pressure from the declining economy.

Hardly. While many states are grappling with budget problems, none are nearly as large as California's relative to its size—$41 billion in a state of 37 million, or $1,108 per resident. Even New York, the next most fiscally pressed state, clocks in with a mere $13 billion for 19 million residents, or $685 per capita.

There's good reason why most states won't fall down the fiscal black hole where California now dwells. This is a state whose politicians, public sector unions and advocacy groups have been living in a fantasy world of overspending, investment-deadening taxation and job-killing regulation. Looking out over the state's prospects and examining the budget deal that legislators have put together (jerry-rigged as it is with revenue gimmicks and unrealistic projections), the only question is who will be begging Washington for more money sooner, the banks, the auto companies or the Terminator?

The similarities between California and the auto companies are especially striking. Neither can afford their workforce. California schools pay their employees 35 percent more on average in wages and benefits than the national average (17 percent more when adjusted for the state's higher standard of living), a significant bite because the state funds much of local education (to the tune of $42 billion last year). Benefits are a big part of these costs. A public employee in California with 30 years of service can already retire at 55 with more than half of his salary as pension, and public-safety workers can get 90 percent of their salary at age 50.

Another budget buster is California's spending on social services, clocking in at about 70 percent more per capita than the national average. Leading the way is state spending on cash assistance programs (that is, welfare), where the state expends nearly three times more per resident than other states. There's a good reason for this rich budget. California's legislature has only reluctantly embraced federal welfare reform, and for years the state has had one of the worst records in moving people from welfare to work because state law limits the ability of welfare administrators to sanction those who refuse to participate in work programs.

he rich program of social service benefits is also burdensome because of the state's large low-wage immigrant population. As Milton Friedman observed in the mid-1990s, you can't have porous borders and a welfare state. The incentives are all wrong. California has become a case-study in that notion. A report by economists working for the National Academy of Sciences in the mid-1990s concluded that the average native-born California household paid about $1,100 in additional taxes because of government services used by immigrants whose own taxes don't come close to covering their cost to society. It would be very interesting to see what the numbers are today.

But California doesn't just have a spending problem. Increasingly it also has economic and revenue problems. Even as I write this other neighboring states are running ads in local newspapers inviting California businesses to move their headquarters out of the state. That's advertising money well spent. A poll of business executives conducted last year by Development Counsellors International, which advises companies on where to locate their facilities, tabbed California as the worst state to do business in.

There are a host of reasons why California has become toxic to business, ranging from the highest personal income tax rate in the country (small business owners are especially hard hit by PITs), to an environmental regulatory regime that has made electricity so expensive businesses simply can't compete in California. That is one reason why even California-based businesses are expanding elsewhere, from Google, which built a server farm in Oregon, to Intel, which opened a $3 billion factory for producing microprocessors outside of Phoenix.

In the race for the exits, residents are accompanying businesses. In just one decade California made a remarkable turnabout, going from a state with one of the highest levels of net in-migration to the state with the second highest level of domestic net out-migration. Typically people either head for the exits because they are seeking more economic opportunity or because they are being driven out by high housing costs. You get a little bit of both in California because the state's zoning regulatory schemes keep housing production artificially low and housing prices high even in a mediocre economy.

As the economist Randall O'Toole points out in his study of housing restrictions, The Planning Penalty, "Thanks to a variety of land-use restrictions, California suffers from the least affordable housing in the nation." The planning penalty, O'Toole estimates, adds from $70,000 to $230,000 to the cost of a home in the Central Valley, $300,000 to $400,000 in Southern California, and $400,000 to $850,000 in the San Francisco Bay area because in California, 95 percent of the population lives on just 5 percent of the land. "The problem is supply, not demand," O'Toole observes. "Austin, Atlanta and Raleigh are growing faster than California cities, yet have maintained affordable housing."

In the last decade, people tried to solve the problem of how to afford expensive housing in California with fancy mortgage products, one reason why the state topped the nation with 523,624 foreclosures last year.

California politicians have been expert at avoiding dealing with these problems. In 2003, enraged citizens recalled Gov. Gray Davis after he announced an impending $38 billion budget deficit. Arnold Schwarzenegger promised reform but delivered only a year of it. When tax revenues spiked in the national economic recovery that started in 2004, California politicians went on another spending spree, increasing expenditures by $34 billion, or 32 percent, in just four years before revenues slumped again.

Then the California legislature wrangled for eight months over the current budget mess, forcing the government to shut down road projects and delay tax refunds because the state needed the extra cash to service its debt. While California technically can't file for bankruptcy, a default on its debt would have shut down financing options for Sacramento and its municipalities until the state agreed to lenders' demands that it get its fiscal house in order. At least one of the state's municipalities, Vallejo, has already filed for bankruptcy and other cities and towns were on the brink before the budget compromise.

California's budget problems aren't going away this time. There is no housing boom (or bubble) about to inflate, as it did in 2004, to help burnish the state's economy, where the unemployment rate is now 9.3 percent, or two full percentage points above the national average. The current budget is only precariously balanced with revenue projections that the state probably won't meet, and with fiscal gimmicks. And much of the federal stimulus money is geared to spending that increases the size of programs rather than fills in current deficits.

In other words, expect the Golden State to be in desperate need of a bailout soon, one that will certainly gain a receptive ear in the White House because Washington can't conceive of our largest state defaulting on its debt, even though the prospect has now sunk California's bond rating lower even than Louisiana's.

But also expect Washington to take some heat if it simply bail outs out California, especially now that we have governors like Mark Sanford of South Carolina pointing out that the federal aid to states amounts to a subsidy by citizens of fiscally responsible governments to states where legislators have chucked responsibility out the window.

Back in the 1970s, New York City was on the verge of bankruptcy and despite a famous headline (Ford to City: Drop Dead), both the feds and New York State eventually bailed out Gotham, but under strict conditions. They imposed a financial control board which required demanding cuts to services, a new, more transparent budget process and several years of budgetary oversight. Maybe what Washington should impose on California will be a national version of a financial control board to shake some sense into state legislators.

Otherwise, we can always allow the state to default on debt and let its lenders start dictating the terms of California's budget reforms. Go ahead, California, make my day.

This piece originally appeared in RealClearMarkets

This piece originally appeared in RealClearMarkets