ABOUT CALIFORNIA.....
(from THE PRUDENT BEAR)
The consequences of Credit excess-induced boom-turned-bust are nowhere more problematic than in the tarnished Golden State.
During the five-year period (fiscal years 1995/96 to 1999/00), California revenues surged 68% ($29 billion) to $71.9 billion (according to state data). This financial flow melee culminated with fiscal 1999/00’s historic one-year 22.7% surge. On the expenditure side, state politicians (and rapidly rising costs) could hardly keep pace. During the five-year period, total expenditures jumped 58% ($24.5 billion) to $66.5 billion. The number of workers on the state payroll increased by about 20% in four years. Overall spending rose 8.2% during ‘95/96, 8.1% during ‘96/97, 7.7% during ‘97/98, and 9.4% during ‘98/99. With the torrent of tax receipts and the seduction of New Era banter, expenditures surged 15% during ‘99/00. Yet the fiscal year ended with a large budget surplus and giddy politicians. And then came fiscal 2000/01. State spending surged 17.4%, but the bull market-induced revenue spigot ran dry. Receipts actually declined almost 1% for the fiscal year - prospective surpluses as far as the eye could see instantly morphing into a deficits black hole. Boom had turned bust, although various makeshift financing mechanism papered over the expanding hole for a couple of years.
Now, with a budget crater of somewhere between $29 billion and $38 billion, state coffers nearly depleted of cash, and lenders increasingly apprehensive, the Golden State is finally approaching The Wall. Yet because the state has been in financial quagmire for some time and has repeatedly averted financial crisis, there is understandable complacency in the media and markets. I would advise against complacency, although the state does appear to have resources to operate through much of the summer. Last week the state’s finance director stated, “California is broke. We are operating as of today completely on borrowed money, and we have no collateral left for additional borrowing capacity.”
For the past two years, the state has used myriad financial gimmicks (including selling tobacco settlement bonds) to postpone the day of reckoning. But the much anticipated recovery in revenues failed to materialize, while several years of hoping allowed the state’s fiscal position to spiral completely out of control (analogous to an unemployed individual that risks ballooning Credit card balances to sustain his lifestyle). Earlier this month (June12), the state issued (with bank support and extra fees) $11 billion of warrants to meet short-term cash requirements. This was the largest-ever issue of such warrants. California now receives the lowest S&P Credit rating of any state, with yields about 40 basis points wider than bonds issued by fiscally challenged New York and Texas. Last week the state sold 30-year bonds at 5.0% (8.4% tax-adjusted yield), about 64 basis points wider than AAA state credits. This spread was up 14 basis points from April, as virtually every other spread narrowed sharply. A Fitch spokesperson was quoted by Bloomberg: “California can’t go on forever living on borrowed money. At some point, the market is going to change its mind” about lending.
June 12 - Sacramento Bee (Alexa H. Bluth): “‘We are perilously close to losing the trust of the market,’ (state finance director) Peace said. ‘This was a sale that was clearly against the credit rating of the banks, not the credit rating of the state.’ The warnings came as divisions intensified between Democratic and Republican lawmakers and as a new statewide poll showed little public support for sweeping tax increases. Republican lawmakers - whose votes are needed to meet the two-thirds requirement to approve a budget - said they will not budge from their position against tax hikes… The Democratic governor’s budget plan calls for a temporary half-penny sales tax increase to pay off $10.7 billion in proposed deficit bonds, as well as increases to cigarette taxes and income taxes for top earners… Davis defended his budget blueprint, despite the lackluster showing in the poll for many of its components. ‘If I have to choose between maintaining our progress in public education, continuing to provide health insurance for children, and continuing to protect you against both crime and terror or raising taxes, I am going to raise taxes,’ Davis said.”
The governor is now under serious recall risk, while Republican lawmakers are resolute in their pledge to not allow tax increases. The democrats are equally resolved to avoid the draconian program cuts that would be required to get the state’s fiscal house in any semblance of order. A recent attempt at a bi-partisan solution collapsed with virtually no support. From Bloomberg: “The plan…would cut 23,000 state jobs (the state has 295,000 workers), raise $6 billion in taxes, and slash $20 billion from state programs.” The only Republican that has announced publicly that he would support a tax increase was quoted: “Without bipartisan cooperation, we’re heading for a fiscal train wreck. Sadly, there is little hope for change.”
Los Angeles Times (Evan Halper and Erika Hayasaki): “During budget crises in previous years - last year’s budget was not signed until Sept. 5 - the state has not had to cut off as much money, but this year is different. A California Supreme Court ruling in May gives Westly very little flexibility. That decision came in response to Howard Jarvis Taxpayers Assn. lawsuit to force lawmakers to take the budget deadline seriously. The court said the state has no legal authority to make many payments if no spending plan is in place. The court also ruled that state workers can be paid no more than federal minimum wage until a budget is passed. The ruling gives state finance officials some time to reprogram their payroll system to make that possible. Westly said the computers will be updated by early September and, if no budget is in place by then, all state workers’ pay will be cut. ‘A no-budget situation is not just academic,’ Westly said. ‘It will create real problems and hardships. This is going to be real hurtful for the state of California.’ Trial courts, child development programs, some mental health services and mandated payments to local governments cannot legally be paid after July 1 until a budget is in place, Westly said. Once the budget is passed, however, all payments will be made retroactively.”
More yesterday from the Los Angeles Times: “On Wednesday, State Controller Steve Westly warned that California’s cash reserves are drawing down, and banks are refusing to lend the government any more money until it straightens out its budget mess.” “Roughly $1.5 billion in state money will stop flowing to schools, colleges, transportation projects and medical providers.”
June 26 - Sacramento Bee (Alexa H. Bluth): “If there is no budget after Tuesday, (state Controller) Westly said: California will not make monthly payments beginning in July that total more than $200 million for K-12 schools and $200 million for community colleges. State employees face drastic pay cuts as soon as late August. Vendors will not receive payments for services rendered to the state after July 1. Westly will continue a tradition of withholding pay from elected officials… Westly said he is limited by a recent California Supreme Court ruling that dictates most state workers be paid the federal minimum wage - $5.15 per hour – when the state is running without a budget.” Quoting the Chancellor of California Community Colleges: “We’re talking about massive shutdowns in access and services that will begin to occur as early as August.” Westly was quoted: “This will create enormous hardships for literally thousands of vendors around the state who are absolutely innocent to the gyration of the budget battles of Sacramento.”
On the revenue side, car registration fees have been raised sharply. From Bloomberg: “Owners of the 26 million registered automobiles in the state will begin to pay on average $158 more a year starting October 1…” Yet, quoting a Republican lawmaker: “This tax increase is not only a bad idea, it clearly violates the California constitution. I’m convinced that the courts will ultimately force the governor to give all the money back.” And so goes the battle…
Los Angeles Times (Dan Weikel): “In a hearing room filled to capacity, customers of Orange County’s largest sewer agency Wednesday both praised and criticized a proposal to double their rates over the next five years to help finance a $2.36-billion capital-improvement program… ‘Our vehicle license fees have just tripled,’ said Paul Durazo of Westminster, who said he has been unemployed for 11 months. ‘It seems like everyone is screaming for more money. Why do we keep getting saddled with the bills?’”
It may prove to be months away, but there is an accident unfolding out in California. And while the Golden State is faced with the largest and most pressing fiscal dilemma, it should be clear at this point that the root of the problem is systemic and structural.
Today from the Washington Post (Dale Russakoff): “State governments’ financial health, which hit the lowest point since World War II last year, has worsened in the past six months, all but ensuring continuing cuts in priority programs such as education, Medicaid and aid to towns and cities, according to a survey released yesterday by the National Governors Association. Budget cuts and layoffs this year produced the deepest state spending reductions in dollar terms since the governors began their fiscal survey in 1977… Still, with revenue declining more steeply and longer than in the previous two recessions -- and with Medicaid costs rising sharply -- many governors are likely to follow the lead of Maryland’s Robert L. Ehrlich Jr., who on Wednesday ordered a spending cut of as much as 10 percent... Medicaid spending - which takes up 20 percent of state budgets - grew 13 percent in 2002, (and) 8 percent this year… ‘Medicaid is becoming the Pac-Man of state government, eating up each additional dollar generated in revenue,’ (executive director of the governors association) Scheppach said.”
The great late-nineties inflation imparted severe distortions. As politicians are bound to do, inflated receipts were immediately spent and extrapolated far into the future. (One of the many reasons it is the crucial role of a prudent, independent central bank to contain excesses!) It is instructive to note that the financial health of our states has actually worsened over the past six months, this despite the Fed’s “reflation” “successes”. But this should be no surprise. After all, the nature and manifestations of Credit inflation are characteristically altered over time, leaving the Fed powerless to regenerate the “favorable” old buoyant (stock market and option-induced) flow to state coffers. Out in California, ultra-easy system-wide Credit conditions are having minimal impact on state revenues. They are, however, severely inflating the price of housing, with generally rising costs for insurance, medical care, tuition, energy and other utilities. Such inflationary manifestations are anything but conducive to either fiscal balance or economic health.
And while the budget quagmire garners some attention, there is a more momentous development unfolding insidiously: the cost of doing business in the Golden State - for businesses as well as state and local government - continues to rise. This is one hell of an intractable structural problem, only aggravated by current monetary policies and dysfunctional Monetary Processes. And there is absolutely no way for the Fed to now even out inflationary effects, with continued rampant Credit inflation only exacerbating terribly distorted price structures and economic maladjustments.
In this regard, California is surely more than a mere microcosm of the general maladjusted U.S. economy, where inflated cost structures find it only more difficult for business to compete globally. With respect to boom and bust dynamics and the great risk of flawed monetary policies, California will prove an historic case study. And while I am no fan of juxtaposing our economy’s predicaments with those of Japan (altogether different economic structure and culture), there is one major similarity: conventional inflation measures completely failed to capture the profound increase in the “cost of doing business.” And as Japan has learned, this is a key structural problem impervious to even the most extreme monetary and fiscal policy measures. It is also a most important issue disregarded by Mr. Greenspan in his serpentine plan to fight a collapsing stock market Bubble with only greater monetary accommodation. This conundrum of an inflated “cost structure” and substandard growth also provides a good example of why learned European central bankers often expound that monetary policy is an ineffective mechanism for rectify structural problems, although it is quite prone to exacerbate them.
As analysts, we’ll follow the goings on in California with keen interest. The state was at the very heart of the late-nineties Bubble, and we are today provided with a case study of how implausible it is to readily (as opposed to requisite arduous adjustment periods) abrogate past inflationary distortions with further inflation. Furthermore, the Golden State remains at the very epicenter of the Fed’s continued failed monetary experiment – with only more desperate measures attempting to sustain an unsustainable Bubble. After all, the Great California Real Estate Bubble has about the strongest inflationary bias today of any asset class. And as difficult as things are today, the very serious trouble arrives when this historic Bubble finally succumbs.
I am convinced that a tottering California housing market was one of the key early-nineties factors that incited a panicked Fed to collapse interest rates (setting in motion the Great Credit Bubble). Ironically, and quite ominously, when the gargantuan Golden State real estate market inevitably falters the Greenspan Federal Reserve will have already frittered away its ammo. The Fed will lack even the sufficient arm strength to dump a little screen pass, let alone muster a last-second Hail Mary from deep in its own endzone.
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