Wednesday, January 19, 2011

California (and Federal?) Insolvency

I saw this on Ben Casnocha's blog:

I've heard variations on this argument from a lot of friends I have who generally support higher government spending - fiscal liberals who believe the US and California safety nets need to be expanded, not contracted.

The issue I have with the argument is that it conflates solvency with productivity. Nobody can deny that the US is the most productive country in the world, as of now, and it's by far the most productive per capita of the countries large enough that they can't be dominated by single industries (financial or petro-resource). Similarly, California is almost certainly the most productive state and is one of the top in productivity per capita, beaten only (I believe) by Alaska (oil) and a few states in the Northeast (no poor unskilled immigrants).

However, that doesn't mean that California's bond situation is fine.

You see, tax revenues in California already reflect that incredible productivity - I don't have any numbers in front of me, but I'd bet you tax income per capita in California is also among the highest in the country. But expenditures per capita are even higher than their productivity can support at today's tax rates. You either need to raise taxes or reduce spending.

Given the high cost of living he alludes to, a 10.5% tax rate in California isn't easily comparable to a 10.5% tax rate in a lower cost state, because you're taking a percentage off the top of a much higher burden. Additionally, it's hard to argue that raising taxes (or even keeping them where they are) is even a remotely optimal solution relative to cutting spending, precisely because California's so productive that the money taken for taxes could be put to MUCH better use, while the money spent by the state government is extremely poorly spent, even by state government standards. Ben Casnocha also has a link to an article here ( about how terribly corrupt and self-serving the political system is.

The "fact" (an allusion to the marketwatch article, not an attempt to be snarky) is that California's government is spending far more than it can afford to, and it does need to choose between raising taxes and cutting spending. Its economic productivity already factors into that. California will default eventually if it doesn't sort out its government - this is mathematically inevitable (the old quote that Buffett always cites - "if something cannot go on forever, it must stop"). It is this productivity that most strongly indicates that taxes really shouldn't be raised if at all avoidable, except pigouvian-style taxes on activities that are actively harmful. Thus, spending will consume California if it doesn't stop.

That's why I would not buy California's bonds, and why I do believe it may default at some point - I don't know when, but I don't see special interests backing off until the day the general populace starts paying attention. Unless Arnold's "jungle primaries" work to reduce the power of special interests, even bigger fiscal problems will come down the pipe eventually. And that day, it won't matter how much California is "bailing out the rest of us" - that money is Federal, and the Federal government is not obligated to bail out states. Maybe they will choose to one day (amidst more cries of moral hazard, this time on a state level), but the Federal government is much better off telling the states NOW that they'll never be bailed out and making some credible commitment to that policy in order to force the states to get their house in order. The government seems to be signaling just that, though who knows how credibly. California would be wise to behave as if it's on its own, and cut spending accordingly.

And a final note that irked me-  just because the pension system is an "actuarial" number doesn't mean you can ignore it. Another Buffett quote comes to mind - "Better to be approximately right than precisely wrong". Arends cites a 136 billion shortfall as not being that big a deal. A pension deficit of 1/13 (not the 1/14 he cites) of the state economy is COLOSSAL. For a state with 37 million people and a $1.8 trillion GDP (not the 2 he cites), a 136 billion shortfall means that California will need to take about $3700 from every single man, woman and child in the state just to pay for the overly generous retirement benefits for state employees. That's just retirement benefits... that's ridiculous!

By the way, if you're reading this and thinking "Hm. The arguments about California could be just as easily applied to the United States as a whole", then we're thinking alike.

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