"Greece, California, etc. - There is No Easy Answer"

Sydney M. Williams

Thought of the Day

“Greece, California, etc – There is No Easy Answer”

May 11, 2010

A news item not widely reported over the weekend, but pointed out to me by an alert portfolio manager and good friend, was that California’s expected revenue from income taxes for April (the largest month for collections) fell $3 billion short at $7.4 billion – a better than 30% miss.

While Europe went into heart failure over Greece’s 14% budget deficit, California’s 20% budget deficit has not elicited the same kind of response. Perhaps it should not. Greece is a sovereign country. California is a state. But California, with $1.8 trillion in GDP, is the seventh largest economy in the world and almost six times that of Greece. Both have the same basic problem – too much debt resulting from promises by the state that cannot be honored. In Greece, public employees can retire at the age of 53. In California, 80% of the budget goes to education and health services. The next highest item, prisons, consumes another 8%. And California’s budget deficits do not include unfunded pension and health care benefits, a subject we wrote about on February 19 and March 11. Using a reasonable discount rate of 5%, the unfunded liability for California’s three largest public unions – CalPERS, CalSTRS, and the University of California Retirement System – exceeds $500 billion, a big number even for a $1.8 trillion economy.

The decision Sunday to provide €750 billion ($960 billon) by European finance ministers to stabilize nations in the Eurozone served to restore investor confidence, but it remains to be seen whether it will address the roots of the problem – public sectors that are too large and too expensive to maintain. Allegedly, any funds the finance ministers provide will require adherence to strict austerity measures, but it was the possibility of such bounds that caused workers in Greece last week to strike so violently, riots that led to the weekend’s decision. Ironically, the cure may aggravate the problem. Just as low interest rates made it easier for consumers to pile on leverage as housing bubbled, the knowledge that a safety net exists may increase the adamancy of public union workers.

The solution for California, as it is for Greece, is simple, but painful to implement. Costs must be cut and revenues must increase. Cost cutting is easy to formulate, but difficult and painful to implement. Revenues can increase in two ways. The fastest way to increase revenues, but the least reliable on a long term basis, is simply to raise rates or levy new taxes. A far better and longer term more certain way is to allow the economy to blossom, which will require cutting taxes. Over the longer term, higher taxes impair economic growth, thereby limiting tax revenues.

Those in policy positions in Europe and the United States are faced with a Hobson’s choice. The problems they face are daunting. On the one hand, the nations of the West, virtually without exception, spend more on entitlements than they can afford, solutions to which will require draconian measures. Most of these countries have flat or declining populations. As the world flattens, they face increasing competition from emerging nations with significantly lower labor costs. On the other hand, long term solutions, such as investing in education and increasing savings, demand short term sacrifices, politically difficult to accomplish during a time when people demand immediate gratification.

Mr. Micawber, a Dickens character not known his financial acumen, however once offered sensible advice to David Copperfield, advice that western nations should heed: “Annual income twenty pounds, annual expenditure nineteen nine and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” The problem of excessive spending is deeply ingrained in nations where entitlements exceed the ability to pay. It is a deeply rooted problem that €750 billion Euros alone will not solve.

As costs are being gutted and debt reduced, confidence in capital markets must be maintained. It is a necessary ingredient to the success of any economy. When confidence fails, as it did in the U.S. in the fall of 2008 and in Athens last week, chaos ensues.

The trick for policy makers will be to adhere to this narrow, ridge-line trail of reducing costs, lowering debt, increasing revenues and encouraging growth, without falling into the abyss.