California vs. Greece: Two Economies in Trouble

by: Tim Iacono

The LA TImes reports that things are not so golden in the Golden State, as Governor Arnold Schwarzenegger once again turns to Washington for help in averting a death spiral.

Facing a budget deficit of more than $20 billion, Gov. Arnold Schwarzenegger is expected to call for deep reductions in already suffering local mass transit programs, renew his push to expand oil drilling off the Santa Barbara coast and appeal to Washington for billions of dollars in federal help, according to state officials and lobbyists familiar with the plan.

If Washington does not provide roughly $8 billion in new aid for the state, the governor threatens to severely cut back -- if not eliminate -- CalWORKS, the state's main welfare program; the In-Home Health Care Services program for the disabled and elderly poor, and two tax breaks for large corporations recently approved by the Legislature, the officials said.

Schwarzenegger also will propose extending a cut in the state payroll that is scheduled to expire this summer. That cut has translated into 200,000 state workers being furloughed three days a month, the equivalent of a 14% pay cut. Lawmakers would have the option of extending the furloughs, imposing layoffs or some combination of the two.

The governor is scheduled to unveil his plan publicly early next month. Administration spokesman Matt David declined to comment on the details.

It shouldn't come as too big of a surprise that the bold moves that were made to close last year's monstrous budget gap - such as moving one twelfth of the state's payroll obligation into the next fiscal year by paying state employees on July 1st instead of June 30th - proved ineffectual over the longer term.

The bad news is that things could get much, much worse before they get better.

In this item over at Barry Ritholtz's The Big Picture, David Kotok offers this sobering look at the similarities between the state of California and the government of Greece:

In the United States, California constitutes about 13% of America’s GDP. If CA were a standalone economy, it would be about the seventh largest in the world. The currency in use in California is the US dollar. The CA government determines its own budget, has its own constitution, operates an internal legal system, and decides its own state tax structure. It is also one of the 50 sovereign members of the USA and has legally bound itself to the rules promulgated in Washington, while attempting to preserve some state rights within our highly federalized legal system. CA and most other states have a requirement to balance an annual budget. There are provisions for emergencies in many of these states, and in the coming year we expect the concept of a financial emergency to be deployed and tested in various state courts. CA recently issued “script” during a short-lived budget crisis when it ran out of cash and until its legislature passed a revised budget. That was not the first time script has been used. We do not expect it will be the last.

In the euro zone, Greece is about 3% of the GDP. It is a sovereign state (country), one of the 16 members of the euro monetary system, and one of the 27 members of the European Union. GR maintains its own budget, although it has pledged to adhere to EU budget rules, which it is currently violating along with most other members of the EU. Under present agreements, penalties will occur if GR is not making a sufficient effort to improve its fiscal situation within a year. We do not expect those penalties to be imposed on GR nor on the other EU states in difficulty. Greece has its own tax structure, constitution, and internal legal system. GR is also covered by the newly developed EU Lisbon Treaty and, like other EU member states, is gradually moving into a Europe-wide economic structure.

California and Greece are both lowly rated by the agencies that appraise the creditworthiness of sovereign debt. CA and GR are also on the top of the list of possible default candidates in their respective currency zones. That list is prepared by CMA DataVision, a service that scrutinizes credit default swap pricing in order to determine market-based assessments of default probability over the next five years. CA and GR are both poorly rated, and their scores (default probabilities) are about the same.

CA is a problem for the Federal Reserve because the state is a very large part of the US economy and because it is suffering from the financial crisis and the collapse of the housing bubble. If CA defaults, it will lose access to credit markets and contract a governmental economy that is 1/7 of the US. That would be a huge blow to the nascent American economic recovery. The Federal Reserve doesn’t directly place its funds in California’s debt; the Fed does function as the central banker for nearly all of the financial entities that underwrite and distribute CA debt. Commercial bank direct holdings of CA’s $76 billion debt are relatively small, due to the construction of the US tax code, which discourages banks from holding tax-free municipal bonds.

GR is a problem for the European Central Bank. The ECB doesn’t own Greek sovereign debt, but it does extend credit to Greece’s national banks in the euro zone, and they hold Greek debt. Furthermore, the ECB must consider the non-Greek euro zone banks, since they too hold Greek sovereign debt. There are rules in place that will disqualify the Greek sovereign debt from use as acceptable collateral in ECB lending operations to banks. These rules apply because of the credit rating downgrades of Greece and will take effect within a year if they are not suspended or deferred. This should motivate the Greek bank lobby to spur the government of Greece to action.

It's a good thing that Californians are as cool, calm and collected as they are (well, except for large-scale riots from time to time), otherwise you might think that protests like this would be in their future.