Obama (Should Say) to California: Drop Dead by: Peter Schiff May 30, 2009
[image: Peter Schiff
picture]<http://seekingalpha.com/author/peter-schiff> Peter
Schiff <http://seekingalpha.com/author/peter-schiff>
During the height of New York City's financial crisis in the 1970s,
President Gerald Ford had the good sense to turn down Mayor Abe Beame's
request for a federal bailout. The refusal prompted the famous New York Post
headline, "Ford to City: Drop Dead." More than 30 years later, as California
Governor Arnold Schwarzenegger makes a similar plea to Washington, I hope
President Obama will show similar restraint. Unfortunately, given Obama's
recent string of unwise economic decisions, it's hard to imagine that his
judgment will suddenly improve.
A federal bailout would spare California from having to make spending cuts
needed to bring its budget into balance. The matter has become urgent since
California voters rejected several tax-hiking ballot initiatives. Rather
than taking the vote as a signal to dramatically curtail spending, the state
turned to the feds. If they get a free pass, the politicians can avoid
fixing any of their past mistakes or preparing California for the future.
California, like many states, expended its bureaucracy as the nation's
bubble economy inflated. When condos flipped like hamburgers and homeowners
flush with equity spent like lottery winners, extra tax revenue flooded into
Sacramento. However, instead of saving the money for a rainy day or paying
off prior debts, the state government simply ballooned its spending. Now
that the bubble has burst, and revenues are severely depleted, it is time
for California to reconsider its excesses.
Governor Schwarzenegger's claim that a federal guarantee is not a bailout is
ludicrous. No one in the private sector will lend California any money
because the state can't pay it back. Just like AIG and GM, it needs federal
help to stay solvent. And although the Federal balance sheet is in far worse
shape than California's, there is one crucial difference: Washington has a
printing press, and Sacramento does not. With the ability to pay off debts
with newly created funds, a federal default is not a concern.
However, if Obama comes to the rescue, none of the needed cuts will be made.
Instead, California will continue to operate its bloated bureaucracy and
will be in constant need of more bailouts. In other words, if Schwarzenegger
gets his bailout, look for him to utter his famous line - "I'll be back."
But it's not just Schwarzenegger who will be back, but governors from all
the other states as well. After all, if the Federal government bails out
California, by what right can they deny similar aid to other states? The
bailout will send a clear message that states do not need to cut spending.
Similar to the reckless behavior that resulted from federally guaranteed
mortgages, federal guarantees on state debt will counteract the market's
attempt to force states to act responsibly. As the market accurately
prices-in the heightened risk of default, California faces staggering
increases in its borrowing cost. Under normal circumstances, this pressure
would force the state to act prudently now to diminish the risk of a future
default. However, by allowing California to evade the "bond market
vigilantes," the stage will be set for much bigger losses.
The moral hazards created by state bailouts are tremendous. With federal
guarantees given to profligate states, those states that had shown greater
fiscal responsibility will face higher interest rates - as their bonds lack
a federal guarantee. This creates the perverse incentive for all states to
act irresponsibly.
Just as government-guaranteed mortgages lead the market to make overly risky
home loans, federally guaranteed state obligations will set the stage for
yet another crisis.
Federal backing of California bonds would effectively turn them into
Treasury bonds, with the added appeal of being exempt from California state
income tax. Therefore, the Treasury will be at a competitive disadvantage
when it looks to issue its own debt to Californians. If it then has to
guarantee the bonds of all the other 50 states, why would any Americans buy
Treasuries when they can get identical credit quality on better terms from
the states? The only real buyers left would be foreigners, who are already
queasy about the Treasuries they own.
The need to make good on state and federal obligations will further depress
the appeal of all U.S. dollar-denominated debt. As a result, as real buyers
flee the market, the Fed will have to run its printing presses even faster
to pick up the slack. This will set into motion a self-perpetuating spiral
of money printing and Treasury sales with a predictable result:
hyperinflation.
In the meantime, by redirecting credit to California that otherwise would
have gone to more credit-worthy borrowers, the government will worsen the
credit crunch for the rest of the country. Since there is only a finite
supply of credit, money borrowed by California will no longer be available
to other borrowers. The effect is a less efficient allocation of capital
that further undermines national productivity.
The only rational policy choice for Obama is to send Schwarzenegger packing.
If he does, California will have no choice but to cut spending or default on
its bonds. My guess is that, with their backs to the wall, the California
legislature will choose the former. However, even if they default, at least
the losses will be borne by those who freely assumed the risks. With a
bailout, the losses will be shouldered by those who were not even parties to
the transactions. If we go this route, we can all say "hasta la vista, baby"
to our prosperity.
http://seekingalpha.com/article/140371-obama-should-say-to-california-drop-dead?source=email
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