Obama (Should Say) to California: Drop Dead

During the height of New York City's financial crisis in the 1970s, President Gerald Ford had the good sense to turn down Mayor Abe Beame's request for a federal bailout. The refusal prompted the famous New York Post headline, "Ford to City: Drop Dead." More than 30 years later, as California Governor Arnold Schwarzenegger makes a similar plea to Washington, I hope President Obama will show similar restraint. Unfortunately, given Obama's recent string of unwise economic decisions, it's hard to imagine that his judgment will suddenly improve.

A federal bailout would spare California from having to make spending cuts needed to bring its budget into balance. The matter has become urgent since California voters rejected several tax-hiking ballot initiatives. Rather than taking the vote as a signal to dramatically curtail spending, the state turned to the feds. If they get a free pass, the politicians can avoid fixing any of their past mistakes or preparing California for the future.

California, like many states, expended its bureaucracy as the nation's bubble economy inflated. When condos flipped like hamburgers and homeowners flush with equity spent like lottery winners, extra tax revenue flooded into Sacramento. However, instead of saving the money for a rainy day or paying off prior debts, the state government simply ballooned its spending. Now that the bubble has burst, and revenues are severely depleted, it is time for California to reconsider its excesses.

Governor Schwarzenegger's claim that a federal guarantee is not a bailout is ludicrous. No one in the private sector will lend California any money because the state can't pay it back. Just like AIG and GM, it needs federal help to stay solvent. And although the Federal balance sheet is in far worse shape than California's, there is one crucial difference: Washington has a printing press, and Sacramento does not. With the ability to pay off debts with newly created funds, a federal default is not a concern.

However, if Obama comes to the rescue, none of the needed cuts will be made. Instead, California will continue to operate its bloated bureaucracy and will be in constant need of more bailouts. In other words, if Schwarzenegger gets his bailout, look for him to utter his famous line - "I'll be back."

But it's not just Schwarzenegger who will be back, but governors from all the other states as well. After all, if the Federal government bails out California, by what right can they deny similar aid to other states? The bailout will send a clear message that states do not need to cut spending.

Similar to the reckless behavior that resulted from federally guaranteed mortgages, federal guarantees on state debt will counteract the market's attempt to force states to act responsibly. As the market accurately prices-in the heightened risk of default, California faces staggering increases in its borrowing cost. Under normal circumstances, this pressure would force the state to act prudently now to diminish the risk of a future default. However, by allowing California to evade the "bond market vigilantes," the stage will be set for much bigger losses.

The moral hazards created by state bailouts are tremendous. With federal guarantees given to profligate states, those states that had shown greater fiscal responsibility will face higher interest rates - as their bonds lack a federal guarantee. This creates the perverse incentive for all states to act irresponsibly.

Just as government-guaranteed mortgages lead the market to make overly risky home loans, federally guaranteed state obligations will set the stage for yet another crisis.

Federal backing of California bonds would effectively turn them into Treasury bonds, with the added appeal of being exempt from California state income tax. Therefore, the Treasury will be at a competitive disadvantage when it looks to issue its own debt to Californians. If it then has to guarantee the bonds of all the other 50 states, why would any Americans buy Treasuries when they can get identical credit quality on better terms from the states? The only real buyers left would be foreigners, who are already queasy about the Treasuries they own.

The need to make good on state and federal obligations will further depress the appeal of all U.S. dollar-denominated debt. As a result, as real buyers flee the market, the Fed will have to run its printing presses even faster to pick up the slack. This will set into motion a self-perpetuating spiral of money printing and Treasury sales with a predictable result: hyperinflation.

In the meantime, by redirecting credit to California that otherwise would have gone to more credit-worthy borrowers, the government will worsen the credit crunch for the rest of the country. Since there is only a finite supply of credit, money borrowed by California will no longer be available to other borrowers. The effect is a less efficient allocation of capital that further undermines national productivity.

The only rational policy choice for Obama is to send Schwarzenegger packing. If he does, California will have no choice but to cut spending or default on its bonds. My guess is that, with their backs to the wall, the California legislature will choose the former. However, even if they default, at least the losses will be borne by those who freely assumed the risks. With a bailout, the losses will be shouldered by those who were not even parties to the transactions. If we go this route, we can all say "hasta la vista, baby" to our prosperity.

Comments

[yellowhoard:]

Mr Freddo,

The Revolting People Party

We're not just mad, we stink on ice!

Jun 01 02:33 PM

[maryanne:]

Great solutions Mr Freddo, here's one more very important: Deny services (welfare, school, medical, emergency room, etc) to Illegals! Deport them all!

Jun 01 03:12 PM

[Twitcher:]

RIGHT ON!!!!!!!!!!!!!!

Jun 01 05:25 PM

[User 424144:]

For the record, the headline "Ford to City: Drop Dead appeared on the front page of the Daily News. not the New York Post.

Jun 02 11:09 AM

[Athrina Zak:]

Insightful thoughts as always. I hope someday other Americans will finally see your way of thoughts and return to thrift. I imagine it has to be sooner than we think.

Therefore I hope you will run for the Senate and do us an honor. Even if you don't win (because Americans can't accept your ideas yet) I think more people will become aware and will start to slowly change their thinking. I certainly was a NY Times reader, super liberal and government trusting until I saw Ron Paul's words during his speech at Google.

I only wish the crisis had come sooner and Ron Paul has been elected. Now I'm trying to get my friends to open their eyes, rethink what we learned in our economic class (our textbook was written by Bernanke!), and do what we know in our heart is right.

Alas, some of them are working for the major finance firms on Wall Street and have their head in their sands because they're afraid of the truth. They don't see that we will become like Zimbabwe or Argentina if don't reform right now. Please help us by getting your words and message out.

Jun 02 07:32 PM

[Jonas Zamora:]

Bailing out California would be akin to giving an alhoholic more wine. Obama would be enabling more unwise financial behavior. That is the last thing our country needs. The sooner we take the right medicine, the better off we will be in the long term. The government is encouraging it's citizens to borrow more to get the economy going when the opposite is needed. If we become net savers, wise spenders, and great givers, our country will be better off.

Jun 02 11:30 PM

[ebworthen:]

Key phrase: MORAL HAZARD

This is true of California being bailed out, along with all the other bailouts.

Have you noticed the home equity loan commercials re-appearing? The incessant Captial One credit card commercials to put your own face on the instrument of personal indebtedness?

"Look Jimmy, I chose 'spaghetti Jimmy' for my Capital One credit card so we will have sentimental feelings about the talisman that will lead to our financial ruin."

It's like offereing a scrapbook or photo album for the HELOC that will lead to your foreclosure. Insanity.

And if you think about it, why shouldn't individuals do what the banks and the government and the automakers are doing? "Do as I say not as I do" doesn't work with children or adults.

Jun 04 11:21 AM

[ebworthen:]

Key phrase: MORAL HAZARD

This is true of California being bailed out, along with all the other bailouts.

Have you noticed the home equity loan commercials re-appearing? The incessant Captial One credit card commercials to put your own face on the instrument of personal indebtedness?

"Look Jimmy, I chose 'spaghetti Jimmy' for my Capital One credit card so we will have sentimental feelings about the talisman that will lead to our financial ruin."

It's like offereing a scrapbook or photo album for the HELOC that will lead to your foreclosure. Insanity.

And if you think about it, why shouldn't individuals do what the banks and the government and the automakers are doing? "Do as I say not as I do" doesn't work with children or adults.

Jun 04 11:22 AM

[ebworthen:]

Key phrase: MORAL HAZARD

This is true of California being bailed out, along with all the other bailouts.

Have you noticed the home equity loan commercials re-appearing? The incessant Captial One credit card commercials to put your own face on the instrument of personal indebtedness?

"Look Jimmy, I chose 'spaghetti Jimmy' for my Capital One credit card so we will have sentimental feelings about the talisman that will lead to our financial ruin."

It's like offereing a scrapbook or photo album for the HELOC that will lead to your foreclosure. Insanity.

And if you think about it, why shouldn't individuals do what the banks and the government and the automakers are doing? "Do as I say not as I do" doesn't work with children or adults.

Jun 04 11:23 AM

[ebworthen:]

Key phrase: MORAL HAZARD

This is true of California being bailed out, along with all the other bailouts.

Have you noticed the home equity loan commercials re-appearing? The incessant Captial One credit card commercials to put your own face on the instrument of personal indebtedness?

"Look Jimmy, I chose 'spaghetti Jimmy' for my Capital One credit card so we will have sentimental feelings about the talisman that will lead to our financial ruin."

It's like offereing a scrapbook or photo album for the HELOC that will lead to your foreclosure. Insanity.

And if you think about it, why shouldn't individuals do what the banks and the government and the automakers are doing? "Do as I say not as I do" doesn't work with children or adults.

Jun 04 11:24 AM

[ebworthen:]

Key phrase: MORAL HAZARD

This is true of California being bailed out, along with all the other bailouts.

Have you noticed the home equity loan commercials re-appearing? The incessant Captial One credit card commercials to put your own face on the instrument of personal indebtedness?

"Look Jimmy, I chose 'spaghetti Jimmy' for my Capital One credit card so we will have sentimental feelings about the talisman that will lead to our financial ruin."

It's like offereing a scrapbook or photo album for the HELOC that will lead to your foreclosure. Insanity.

And if you think about it, why shouldn't individuals do what the banks and the government and the automakers are doing? "Do as I say not as I do" doesn't work with children or adults.

Jun 04 11:27 AM

[ebworthen:]

Key phrase: MORAL HAZARD

This is true of California being bailed out, along with all the other bailouts.

Have you noticed the home equity loan commercials re-appearing? The incessant Captial One credit card commercials to put your own face on the instrument of personal indebtedness?

"Look Jimmy, I chose 'spaghetti Jimmy' for my Capital One credit card so we will have sentimental feelings about the talisman that will lead to our financial ruin."

It's like offereing a scrapbook or photo album for the HELOC that will lead to your foreclosure. Insanity.

And if you think about it, why shouldn't individuals do what the banks and the government and the automakers are doing? "Do as I say not as I do" doesn't work with children or adults.

Jun 04 11:27 AM

[ebworthen:]

Key phrase: MORAL HAZARD

This is true of California being bailed out, along with all the other bailouts.

Have you noticed the home equity loan commercials re-appearing? The incessant Captial One credit card commercials to put your own face on the instrument of personal indebtedness?

"Look Jimmy, I chose 'spaghetti Jimmy' for my Capital One credit card so we will have sentimental feelings about the talisman that will lead to our financial ruin."

It's like offereing a scrapbook or photo album for the HELOC that will lead to your foreclosure. Insanity.

And if you think about it, why shouldn't individuals do what the banks and the government and the automakers are doing? "Do as I say not as I do" doesn't work with children or adults.

Jun 04 11:27 AM

[ebworthen:]

Key phrase: MORAL HAZARD

This is true of California being bailed out, along with all the other bailouts.

Have you noticed the home equity loan commercials re-appearing? The incessant Captial One credit card commercials to put your own face on the instrument of personal indebtedness?

"Look Jimmy, I chose 'spaghetti Jimmy' for my Capital One credit card so we will have sentimental feelings about the talisman that will lead to our financial ruin."

It's like offereing a scrapbook or photo album for the HELOC that will lead to your foreclosure. Insanity.

And if you think about it, why shouldn't individuals do what the banks and the government and the automakers are doing? "Do as I say not as I do" doesn't work with children or adults.

Jun 04 11:28 AM

[Big Jim:]

Good on you, the real problem is a failure of the CA voter to take their obligations seriously and pass tax and spending reform or elect people who will. Tell them to drop dead but do not give weak nod to lower tax nuts. Lower taxes are not a policy.

On May 30 04:57 PM PeterB wrote:

> The failure of the ballot measures in California cannot purely be
> attributed to a refusal to pay more taxes, since the measures included
> future spending limitations seen as draconian by many "liberal" or
> left-oriented organizations. The complex measures included significant
> provisions anathema to each side, which probably overweighed those
> provisions attractive to each side, reflecting the growing extremism
> of politics in the state, also an apparent precursor of the same
> trend in national politics. As an example, I found items from two
> gay-rights organizations, one favoring a YES vote on most measures,
> the other a NO vote on most measures. See also www.couragecampaign.or...
> for a position listing of self-called progressive organizations,
> mostly opposed to the measures. Perhaps the most certain message
> being sent to the California political structure was to get its house
> in order, and actually make the budget and taxing decisions the state
> so sorely needs, rather than grand-standing incompatible positions,
> and shunting the decisions to the ballot.

Jun 05 04:09 PM

[Apple Diner:]

Frankly, California must fail before it can get "better". There are too many people and pet projects drawing funds from the state with no way to pay for these ridiculous "free" services. Layoffs need to be accelerated, currently free services need to move to a 'pay to play' model, and more government owned property and services need to be privatized, especially the state lottery, toll roads and parking lots. We'd be more than halfway there with these changes, then I'd recommend lowering state taxes to better compete with Oregon and Washington state, with special tax-free incentives for large businesses who are willing to relocate to California... Think about it and get back to me by tomorrow. ;)


On May 30 10:41 PM Moon Kil Woong wrote:

> Have you ever read California's 250 page Constitution? If you had
> read the largest Constitution in the world you would know why California's
> problems can't ever be solved until you rewrite it. You would also
> know why California is always broke, steals money from its counties,
> has the highest percentage prison population, and why it doesn't
> matter who you elect because 97% of the budget is pre-allocated.
>
>
> California's woes have nothing to do with actors being elected as
> Governor. In fact, California can elect anyone or anything to governor.
> It wouldn't make a difference with the constitution they have. Any
> money going to them should have a simple requirement: do your homework
> and rewrite your constitution into something that 1) works 2) doesn't
> allow contradictory statement in every article 3) requires elected
> officials to actualy do something 4) doesn't steal tax money from
> counties that is suppose to go to roads, bridges, and actual services
> people depend on the government to provide, 5) don't lock people
> in jail for life for driving over the speed limit (Use a little jurisprudence
> when sentencing. You can't afford it and are breeding gangs and criminals
> galore since you can't manage the prisons either. Maybe think of
> rehab for drug offendors for one thing or years of community service.),
> and 6) doesn't tax your citizens so high they think of fleeing the
> state every April (making you wonder why you are hemmoraging your
> crown jewel, the electronics industry to other States).

Jun 09 07:52 PM

[Apple Diner:]

Lower taxes are the only way California will be able to compete to retain the very "brains" and wealth we need at this time. The state must do whatever it takes to get spending under control, including mass layoffs of government employees and severely curtailing or eliminating government programs. Focus on attracting businesses back to our state and the rest will take care of itself.


On Jun 05 04:09 PM Big Jim wrote:

> Good on you, the real problem is a failure of the CA voter to take
> their obligations seriously and pass tax and spending reform or elect
> people who will. Tell them to drop dead but do not give weak nod
> to lower tax nuts. Lower taxes are not a policy.
>
> On May 30 04:57 PM PeterB wrote:

Jun 09 07:55 PM

[TrembleTheD...:]

Obama shouldn't do that, but quiet a few Californians will be saying it on their own:

seekingalpha.com/user/...

Jun 11 05:00 PM

[Mad Hedge F...:]

He will. Sadly, once again, my home state of California is threatening to commit suicide. The formerly Golden State officially runs out of cash in 50 days, and our body building governator, Arnold Schwarzenegger, refuses to borrow any more until the legislature delivers $24 billion in spending cuts. Standard & Poor’s has placed it on Credit Watch, and premiums for credit default swaps on the state’s debt have already spiked back up to 300 bp. I got a letter today from Robert Birgeneau, Chancellor of the University of California at Berkeley, where my son goes to school, telling me that his budget shortfall has just leapt from $67 million to $145 million, and that tuition is going up 9.3%, while staff wages will be cut by 8%, and financial aid will be chopped to the bone. And this is the place we are counting on to deliver the scientists, engineers, and professionals who are supposed to keep us globally competitive. Pleas to Obama for a bailout have already been brushed aside, like a pesky fly. He rightly sees us as an alcoholic friend asking to buy him just one last drink. A default would be no joke, as California accounts for 15% of US GDP, and ranks as the world’s eighth largest economy. Few realize that the state is home to the country’s second highest per capita payers of tax revenue into Treasury coffers, after New York (Sarah Palin’s Alaska is the lowest). Hardly a day goes by without banner headlines about closing state parks, cancelling local sports programs, or freezing payments to mothers with dependent children. In fact, most state residents now prefer the Sacramento government to go bust in order to bring a speedier resolution. There is only one possible solution. A new governor holds a constitutional convention to reduce the vote to pass a budget from two thirds to 50%, or a statewide voter initiative accomplishes the same. Maybe ex Ebay CEO Meg Whitman, who will run for Arnold’s job next year, can pull this off?

Jun 16 11:29 PM

[Al-USA:]

Ok, just to be clear, California does not have a problem, capitalism has the problem. Whatever happens, California, and its people, will still be there. Capitalism, as a viable economic model, is the one on the verge of collapse. Get it straight people.

Having said the above, a very informative article by Mr. Shiff.

Jun 18 09:14 PM