California's Troubles Are America's

Last week, major banks announced they would no longer offer cash for the IOUs written by the state of California. At the same time, China proposed that the U.S. dollar be replaced as the world's official reserve currency. Although seemingly unrelated, these two developments have at their root the same issue: uneasy creditors.

Inspired by Washington's profligacy, California's Democratic majority long pursued a policy of populist politics, supercharged by referendums, which called for increasingly massive expenditures. Exploding deficits were the natural result. Now, it has reached the point where holders and potential buyers of California debt have lost confidence in the state's ability to ever repay.

Ever since President Nixon severed the dollar's link to gold in August 1971, the U.S. has embarked on a monetary policy that has been both a blessing and a curse. The blessing was found in the dollar's reserve status, which allowed for monetary flexibility that no other country could attempt.

But therein lay the curse, as gross economic imbalances were allowed to grow unaddressed. Our currency's exportability obscured the fact that our government spending was financed largely by inflation and debt.

It appears that California politicians assumed that they could follow the same model. They began to authorize massive expenditures on freeways, schools, universities, and parks. In their thirst for votes, they introduced a vast array of referendums on entitlement issues.

This is quite unlike Switzerland's successful forays into direct democracy, which restricted referendums to election laws and constitutional matters. Absent limits to their purview, California voters inevitably granted themselves new benefits from the public purse, financed by increased taxation and debt. This led to ever higher voter demands and a dramatic rise in real estate values.

In imitating the example of Congress, California's politicians made one crucial error. Like the Administration, they could tax and borrow. But unlike Washington, California could not print money.

Recently, California's politicians have realized that there are limits to taxation, and even debt levels. The real estate recession has hit California particularly hard, while rising unemployment and bankruptcies have reduced the local tax base significantly.

The resulting deficit has scared bond buyers. Creditors were further alarmed when President Obama expressed his unwillingness to divert federal aid to California. Unable to finance its expenditures, California has effectively tried to issue its own currency in the form of IOUs. But banks are now refusing them.

Congress faces a similar predicament. China, the world's largest gold producer and holder of surplus U.S. dollars (or IOUs), is concerned about America's ballooning debt and the depreciating value of the dollar. China is proposing that the dollar be replaced as the world's reserve currency. If this were to happen, the U.S. would lose its “reserve privileges”, which would adversely affect its ability to issue new debt and cause consumer prices to soar. Untold damage would be done to both America's morale and its potential for a quick economic revival.

Sacramento might have followed Washington down a blind alley, but it was first to hit the wall. When the central bank can no longer keep the federal government on life support, California's troubles will be America's. Watch the painful process of spending cuts that California is undertaking, as it portends our collective future.

The lesson is that Washington is a bad influence and a bad mentor. Our trust is placed where the governments' behavior justifies it: fast-developing countries, such as Brazil, India and China, as well as major natural-resource suppliers such as Canada, Australia, and New Zealand (collectively known as BIC-CAN).

The BIC-CAN countries offer very appealing investment opportunities, especially in the fixed-income world. Meanwhile, California and U.S. Treasury bonds are just too big a risk.

Comments

[socrateazz:]

I like your article. There is a lot of reality in California's predicament. But I doubt California has a clue how far overboard the state has actually gone. They are still above the water today! And they believe they can keep from drowning. They are right. The policy changes neccesary are so great the legislature can not even understand what needs to be done. Those in charge need to be freed of control and realistic people need to take their place. Will it happen? Maybe!

Jul 16 04:31 AM

[User 353732:]

1. First, the dollar was decoupled from gold i.e a decoupling from self control and discipline that forces people and nations to make hard choices about resource allocation and priorities: the decoupling facilitated the ascent of instant gratification
2. Second, the dollar was decoupled from the real wealth creating capacity of the nation as dollar denominated debt began to soar i.e the decoupling established the primacy of consuming and borrowing over producing and saving
3. Now the dollar has been decoupled from credibility as federal, state, muni and bank debt manifestly exceeds any capacity to repay ie the decoupling is creating the conditions for massive dollar debasement via inflation and state/muni debt repudiation , which means demotion of the dollar from the role of sole reserve currency.....this is what the Chinese, Russians and now Indians, Brazilians and even South Africans are complaining about: as the US Govt loses cerdibility so the US loses global stature and the symbol of that stature, the dollar, abdicates its reserve currency function.
4. The next decoupling, if it were allowed to happen, via the unconstrained printing of fiat money by the Federal Govt, then Calif, then other states and then large Munis(why shouldn't NYC and LA issue their own fiat currencies? NYC IOUs, and LA IOUs ?) this will mean a decoupling from the Constitution ie a decoupling from both civil and property rights, the fragmentation of the Union and the end of the American experiment

Jul 16 05:46 AM

[morph366:]

To take liberty with some well known lyrics the land of dreamers, schemers and telephone screamers seems to be running on empty now.
However this week's Economist magazine claims that just as before California will re-invent itself as part of the great American experiment.

The BIC-CAN economies will find it hard to flourish if the sixth largest economy in the world is heading for a terminal decline and I certainly would not hold out hope for the de-coupling thesis if the US follows suit as well.

Jul 16 06:36 AM

[atlasman:]

The real question is will California's solution be America's solution. I have heard rumblings that they are considering a flat tax. If they have the guts to do it, it would be a great start to solving the countries problems by scrapping the current income tax.
-AM

Jul 16 08:05 AM

[CautiousInv...:]

California is indeed a microcosm of the broader US.

Through various referendums , California voters have attempted to restrain spending through denying the state access to additional monies. Undeterred by these efforts to contain spending, the state legislature continued to follow ruinous fiscal and spending policies financed through issuance of debt.

Unable and unwilling to make the required budget cuts, the state continues to spend and is issuing IOU's which are now being refused by banks who view the creditor bankrupt.

Moving from Sacremento to Washington, the mindset and policies are the same but Washington can continue to borrow, and failing that, create money. But over time, Sacremento's IOU's will increasingly resemble the future dollar, a once splendid fiat doomed to worthless debasement owing to selfish political agendas built upon greed, desires to be reelected and constitiency politics.

The need to dramatically reduce spending and borrowing is falling upon deaf ears; the political elite press forward with their egalitarian visions of wiping out inequities in distribution of income, by enacting environmental legislation that will crush the only remaining productive industry remaining on our shores and passing health care reform that will disembowel small businesses who will be fined should they not comply.We are debasing the dollar and strangling the remaining productive sectors and people of the US.

We to will be encouraging others other to buy are IOU's when it is know that there is insufficient wealth and productive capacity to repay the IOU but in a depreciated form.

Jul 16 09:12 AM

[John Bowman:]

When I got out of college in the late sixties, I had a dream that I would eventually move to California from the east coast. It was flourishing back then. I loved the laid back attitudes of their residents and their innovative mindset.

Now it's just a monument to modern day excesses and a gigantic welfare state. It's a shame that it happened in just one generation.

Jul 16 09:28 AM

[dybydx:]

haha, interesting view of linking sacremento to DC.

i do believe the bankers did the right thing refusing to accept IOU's. this is a badly needed wakeup call for cali voters. i dont blame the bankers. they didnt get cali into this debt mess, it was the voters and their representatives.

Jul 16 09:30 AM

[lance sjogren:]

The federal government is headed on the same path as California but can go a little further before it hits the wall because it can print money out of thin air.

The one possible difference is: As the federal government prints money it creates (with some time lag) inflation. In the economic downturn, wages are not going up. Even if we adopt banana republic style union elections (card check) I doubt wages will go up, and certainly unemployment will go up.

So, the standard of living will go down due to Fed-generated inflation.

Note that this is a sort of corrective feedback loop: Our economy, especially government, has been living beyond its means, and inflation will be reducing the standard of living, i.e. reducing our unsustainable overconsumption.

This contrasts with California where there is no self-corrective mechanism since the state cannot create inflation, thus the only solution to California's woes is to wield the budget meatax.


Now, here's a cheery one for Californians: Not only will you be seeing massive budget cuts, but the federal government will be creating inflation which causes those state and local tax dollars to lose a substantial fraction of their value.


Thus, reckless states like California are going to see a double whammy.

Jul 16 09:50 AM

[Gregman2:]

California can get back on its feet, but it will be painful, especially to state employees, retirees, and the unions. California would do well to explore a modified bankruptcy of sorts (maybe even create a new Chapter.;-) Talk about cutting edge!

Jul 16 10:58 AM

[_richard_:]

"China is proposing that the dollar be replaced as the world's reserve currency".

But replaced by what currency, or what drawing rights? Those who express discontent do not suggest any currency sufficiently liquid. Drawing rights are not liquid, nor are stocks of gold. Oil is liquid only as a substance, not as a medium of exchange. And the countries producing the Yen and the Euro are arguably in more precarious straits than ourselves.

Until an alternative emerges, the dollar is here to stay.

Jul 16 11:31 AM

[MarkitWacha:]

I wouldn't want to be living in California for the next few years. It will get as bad as Michigan before the people wake up.

Jul 16 12:09 PM

[awake09:]

Commentor 353732-- I'm going to keep my eye on you. Well said, and unfortunately too true.


On Jul 16 05:46 AM User 353732 wrote:

> 1. First, the dollar was decoupled from gold i.e a decoupling from
> self control and discipline that forces people and nations to make
> hard choices about resource allocation and priorities: the decoupling
> facilitated the ascent of instant gratification
> 2. Second, the dollar was decoupled from the real wealth creating
> capacity of the nation as dollar denominated debt began to soar i.e
> the decoupling established the primacy of consuming and borrowing
> over producing and saving
> 3. Now the dollar has been decoupled from credibility as federal,
> state, muni and bank debt manifestly exceeds any capacity to repay
> ie the decoupling is creating the conditions for massive dollar debasement
> via inflation and state/muni debt repudiation , which means demotion
> of the dollar from the role of sole reserve currency.....this is
> what the Chinese, Russians and now Indians, Brazilians and even South
> Africans are complaining about: as the US Govt loses cerdibility
> so the US loses global stature and the symbol of that stature, the
> dollar, abdicates its reserve currency function.
> 4. The next decoupling, if it were allowed to happen, via the unconstrained
> printing of fiat money by the Federal Govt, then Calif, then other
> states and then large Munis(why shouldn't NYC and LA issue their
> own fiat currencies? NYC IOUs, and LA IOUs ?) this will mean a decoupling
> from the Constitution ie a decoupling from both civil and property
> rights, the fragmentation of the Union and the end of the American
> experiment

Jul 16 01:48 PM

[awake09:]

"Wake up"? These obtuse people think they are the only "awake" people on Earth. It begins in the schools they place their children, the humanistic doctrines they embrace, and the zombie-like trance they are in when it comes to "taxing the rich," etc. All of those cliches come from here, the land of taxpayer funded giveaways. They won't wake up, they will simply die in their own failures, but with an upheld fist of defiance as they sink into the quicksand. Screw the coastal Californians, they made the cesspool that I have to swim in.


On Jul 16 12:09 PM MarkitWacha wrote:

> I wouldn't want to be living in California for the next few years.
> It will get as bad as Michigan before the people wake up.

Jul 16 01:55 PM

[Bjarne Jensen:]

Richard: By creating currancy swaps with their trading partners, China has already begun to incrementally establish the Yuan as the new trading/reserve currency. It's just a matter of time until the only country that needs the dollar is the United States.



On Jul 16 11:31 AM _richard_ wrote:

> "China is proposing that the dollar be replaced as the world's reserve
> currency".
>
> But replaced by what currency, or what drawing rights? Those who
> express discontent do not suggest any currency sufficiently liquid.
> Drawing rights are not liquid, nor are stocks of gold. Oil is liquid
> only as a substance, not as a medium of exchange. And the countries
> producing the Yen and the Euro are arguably in more precarious straits
> than ourselves.
>
> Until an alternative emerges, the dollar is here to stay.

Jul 16 04:05 PM

[Evaluator:]

Make that the liberal voters and the democratic law makers. My hat is off to Arnold for taking a stand and holding the line on more taxes that the dems want to fund the "great society" mentality. Rather than take the bull by the horns and enact legislation to reduce spending, the lawmakers put the decisions to tax their way to utopia to the people in the form of propositions, who resoundingly rejected it. The one proposition that Californians did agree on, if the politicians couldn't pass a budget, the politicians shouldn't receive a paycheck until they could pass a budget. There's too many special interest (union) lobbyist in Sacramento with their special interest groups taking priority over all other concerns and welfare of the citizens of California. 40% of California's buget goes to education. Strangley enough, the teacher's union is one of the largest or strongest lobbying groups in Sacramento. Perhaps eliminating the lobbyist from politics is the answer, both in Sacramento and in Washington. I think the politicians are paid a generous salary as it is. California and the country in general need to get back to the basics. At least we don't have any Czars yet!! As far a Washington, we all need to start getting concerned abount the Obamanation of the country. California is just the tip of the iceburg.


On Jul 16 09:30 AM dybydx wrote:

> haha, interesting view of linking sacremento to DC.
>
> i do believe the bankers did the right thing refusing to accept IOU's.
> this is a badly needed wakeup call for cali voters. i dont blame
> the bankers. they didnt get cali into this debt mess, it was the
> voters and their representatives.

Jul 16 07:06 PM

[Socialism c...:]

"California's problems are America's"

There are two meanings in this, blended into one. They need to be split -- one is correct, the other not.

1) Yes, CA's problems will affect the rest of the U.S. Certainly true.
2) No, CA's problems are not ours to solve -- Californians must take responsibility for the problems they created by pursuing the policies they have chosen. This leads to a discussion on another of your statements:

"Inspired by Washington's profligacy, California's Democratic majority long pursued a policy of populist politics, supercharged by referendums, which called for increasingly massive expenditures."

California's problems are due to rampant socialism and vast entitlement government. In that, we certainly see a parallel with the U.S. government, and to varying degrees, other state governments. To propose that CA's Dem majority was engaged in populism is FALSE -- socialism is NOT populism, since what is best for the people is never to make some of them wards of the state while pilfering from other segments against their will to pay for it! That is the violation of personal property rights of many, and the subjugation and dependency creation of many others. Faux populism -- but, yes, it has served the Dems well politically since on the surface level, increasingly large groups of people have *felt* as though they were getting something of value from the government. The cost could be pushed off further into the future. As we see now, though, the piper eventually has to be paid, as always. This faux populism was a false promise.

Why, through the years of history, can we not maintain the lessons we keep learing? There are a couple very relevant ones that continue to hold true again and again:

1) There is no free lunch -- for anyone; each must earn his way in the world

2) Big government is NOT workable; it always gets out of control and ends up working against the interests of the people, whether that was its intention to begin with or not. Time for some serious downsizing.

Jul 17 11:40 AM

[Mad Hedge F...:]

You bet!. The good news is that California has finally come to a budget compromise, covering a $26.3 billion shortfall with $8.8 billion in spending cuts in education, $4.4 billion in forced borrowing from local governments, $2.2 billion in social programs, $1.3 billion in unpaid furloughs of state employees, and $3.5 billion in accounting fudges. The bad news is that we are giving San Diego back to Mexico and San Francisco to China, who already own most of it anyway. As for me, I am going to spend the weekend putting iron bars up on my windows, installing a new burglar alarm system, and setting up booby traps in my front yard. Part of the deal involves the release of 26,000 of the Golden State’s 155,000 prisoners. While 10,000 will be deported to Mexico, I’m sure the rest will be dumped in my back yard.

Jul 23 02:00 PM