California's Budget Crisis
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Yesterday, the state of California began to pay for its current expenses by issuing bonds, or IOU's. The legislature's inability to come to an accord over the budget, which is $24 billion in the red is the cause. Already we are hearing news that Wall Street is going to devalue California's bond rating significantly. They might devalue it to "junk" status, thus creating an inordinate amount of instability in the bond markets globally. Once downgraded, CA's rating is likely to fall below the minimum level legally required for most money market funds, forcing the funds to sell their California bonds. This will come at a cost of millions of additional dollars in interest rates for the state, thus driving them deeper into more DEBT.
In short, they're broke and they don't know where they're going to get their money from. The situation will only get worse from here. Right now, they're in a debt spiral. A lower bond rating means that the state's borrowing costs are going to increase. The only way they can pay their outstanding obligations is through the issuance of debt, which will cost more to issue now that their bond rating has been downgraded. They're stuck in a bad cycle and can't get out.
How could a state that's home to the country's largest manufacturing belt and to Silicon Valley, the nation's largest high tech center, be bankrupt? California is the nation's most populous state with over 38 million people. It has a GDP of over $1.8 trillion, making it's economy larger than Russia, Brazil, or India's. Yet the state's finances are collapsing and it's unemployment situation is the worst it's been since the 1940's. They are projecting a 24 billion dollar deficit, and that is their most rosy projection, that's assuming that the economy will start recovering by the end of the year. So far, it appears like there's no sign of that happening yet. What CA does have going for it is an enormous amount of human capital, resources, and technical expertise. The only thing that it's lacking is MONEY or CREDIT.
Either way, the risk of CA defaulting on it's debt is significant. Years of budgetary mismanagement, overspending due to overly optimistic revenue projections, and political cronyism is contributing to the state's collapse. What has brought it to the brink is the economic slowdown, which is impacting the state particularly hard.
One solution to their problem could the formation of state owned "bankers bank" that can issue credit to small businesses, schools, farmers, developers and entrepreneurs. North Dakota has a similar state bank in place that's highly successful. In fact, even in today's economic climate, ND is still running a $1.3 billion surplus, largely because of their state bank. But they didn't get involved in fancy finance, nor were they affected by this decades real estate boom and bust. ND didn't take on a lot of unnecessary risk; they are much more conservative than other people when it came to finance. Their economy is still strong and largely unaffected by the economic slowdown. Perhaps that should be a lesson to all of us!
Nevertheless, CA can still use this as a solution. Assuming that they put all of this year's projected revenues, $128 billion, into a state owned banker's bank, it can easily produce over a $1 trillion in loans, assuming a 10% reserve requirement. But they don't really need to put a full year's worth of revenues into this newly formed bank; all what they'll need to cover their deficit, assuming an 8% reserve requirement, is about $2.3 billion in deposits (directly guaranteed by the state gov't) and $2 billion in capital, all of which can easily be raised. Doing this will generate enough money to fund the state government for the year. The loans generated by this state owned bank will largely be very low interest; perhaps they might just charge the service fee on the loan. They can offer low interest loans for startup firms, students, and they could even buy up municipal bonds from public agencies and local government. This will immediately help in stimulating economic growth by getting credit moving again while reducing the funding shortfall in local government and state agencies.
Since the state will own the bank, they won't have to worry about shareholders or profits. In other words, they won't need to take on unnecessary risk to generate short term profits. They could lend to creditworthy borrowers at a very low rate; and on loans made to the state, the state would get the interest, thus making the loans interest free. That's really the key to solving CA's budgetary problems. As it stands now, the state is issuing bonds to fund it's operations at a high interest rate. This will get rid of that problem, plus it will allow the government to fund itself, thus reducing the state's escalating debt load while reducing it's total cost of borrowing. The profits generated from the bank would be returned to the state, thus creating yet another strong revenue source for the state.
So California could create all the credit it needs to fund it's operations, with money to spare. And they won't even need to ask Obama for a bailout! And they won't need to enact austerity measures and higher taxes. Other states (47 out of 50 states are currently facing budget deficits) can easily generate their own credit using a similar structure. North Dakota does it successfully, and if implemented correctly (that's the key!) with strong risk management procedures in place, it can solve many state's budgetary problems.
