From direct democracy to direct federal financial rule in California

California’s public finances are in many ways a microcosm of those of the US as a whole. Admittedly, the state government’s deficit is tiny compared to that of the federal government. The state of California has a budget deficit this year of $26.3bn (about 1.5% of state GDP, which was just over $1.8 trillion in 2007), on revenues of just $113bn.  Its total outstanding stock of state debt is also small, with just $59bn in general debt, $8bn in bonds linked to securitised revenues and about $2bn in commercial paper. In contrast, the US federal government is about to run a budget deficit in the 13 to 14 percent of GDP range (that is, the federal deficit is about the size of the state of California’s GDP!).

California, like every US state, will be hit by federal deficit and by the manner in which this is eventually brought under control again, be it through tax increases, public spending cuts, inflation or sovereign default.  The state deficit, and the manner of its eventual resolution, represents pain for Californians on top of the shared misery they will endure as a result of California’s contribution to the resolution of the unsustainability in the federal public finances.

Like most US states, California has a balanced-budget rule that is supposed to prevent if from running deficits.  Such a balanced-budget rule coexists a tad uncomfortably with a positive outstanding stock of public debt and with the need to eliminate a recurrent state deficit.  Obviously, one man’s balance is another man’s deficit.

Because California cannot achieve agreement in its state legislature on how to eliminate its deficit, the balanced budget rule continues to be flouted as it has been flouted during similar episodes of political stalemate before.  The state is financing its unconstitutional deficit by paying suppliers and employees in funny money, or scrip, politely referred to as IOUs, which are simply interest-bearing bearer debt instruments issued by the state or transferable state bearer bonds that dare not speak their name.

The state still services its outstanding stock of official debt with cash, which is why no formal event of default has been called yet, but de-facto California has already defaulted on its financial obligations and commitments by paying suppliers and employees with funny money rather than with cash.  When the banks stop accepting the IOUs except possibly at massive discounts, which will happen soon unless an early resolution of the budgetary stalemate is achieved, the state of California will close down for business.  Municipalities and counties dependent on state funds will follow suit.  Before long the teachers won’t teach, the fire fighters won’t fight fires, the police won’t maintain law and order and neither garbage nor taxes will get collected.  It will be a grand Hobbesian experiment.

The similarity between California’s state government budget deficit and the Federal deficit lies not so much in their magnitudes as in the political and institutional dysfunctionality that created and sustains both of them.

Like the country as a whole, California has become increasingly polarised politically.  There is no common ground, no willingness to engage in serious negotiation and compromise.  The state’s social capital, like that of the nation as a whole, has been thoroughly depleted.  The willingness and capacity to strive for let alone achieve a new consensus appears absent, despite the presence of two rather unifying personalities at the head of both the federal and the state executive branches of government.  Unfortunately, both president Obama and governor Schwarzenegger appear out of step with the mindless majority of their compatriots.

In the federal Congress, there is no majority either for the future steep tax increases or the future large cuts in public spending that will be required to restore federal fiscal sustainability.  In a nutshell, the Republicans will scupper any future tax rise and the Democrats will veto any future cut in public spending.  The same is happening in California’s legislature.  Both the President of the USA and the Governor of California are significantly more sensible and moderate than their parties, and less beholden to narrow special interests, but neither has the political clout to compel the least painful restoration of fiscal-financial sustainability.

California also suffers from the curse of direct democracy. Its “propositions”, single-issue referenda on anything, including budgetary matters, have effectively made the state ungovernable.  One of the great curses of the internet is that ‘direct democracy’ – where everyone eligible to vote is able to cast a vote on each of a long list of single issues – is now as easy technologically as it is damaging to informed and balanced decision making.  The founding fathers, no doubt after getting an earful from the founding mothers, knew what they were doing when they gave is representative democracy instead of direct democracy.

So what is to be done?  For the fiscal plight of the US as a whole, prayer is all I can recommend.  For California and other states and municipalities trying to squeeze financial support out of the federal government, it is key to attach suitable penalties to any bestowal of federal financial largesse.  The obvious penalty to discourage recidivism is to impose direct financial rule by Washington over the state of California in exchange for fiscal financial support for the state of California from the federal government.  That is what happens with municipalities and counties that go or are about to go belly up financially and that turn to the state government for financial support.  It is what happens in other federal systems when a state government knocks, cap-in-hand on the back door of the federal Treasury, begging to be rescued.

Direct financial rule would mean that neither California’s state executive nor the its state legislature would have any financial decision making powers until financial normalcy is restored.  California’s ‘proposition mechanism’ would also be suspended for any proposition that would have financial implications for the state.  A federally appointed Board of Overseers would have full powers to cut public spending, raise existing taxes or introduce new taxes or charges until the budget deficit has been eliminated in a sustainable manner.

Such direct financial rule reduces the state of California to a legally and financially incompetent minor.  Because that is exactly the way the state has acted and continues to act, this is both efficient and fair.  The only irony is that this direct financial rule rule would be excised by an entity appointed by a federal government that itself is structurally incapable of putting its fiscal house in order.  But that is an irony Californians will have to learn to live with.  Beggars can’t be choosers.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

Maverecon: a guide

Comment: To comment, please register with FT.com, which you can do for free here. Please also read our comments policy here.
Contact: You can write to Willem by using the email addresses shown on his website.
Time: UK time is shown on posts.
Follow: Links to the blog's Twitter and RSS feeds are at the top of the page. You can also read Maverecon on your mobile device, by going to www.ft.com/maverecon