California's Economy: Too Big to Fail?

California's economy is in deep distress. Political gridlock is preventing tax increases and spending cuts, and the recession has pushed its deficit over the edge. Governor Arnold Schwarzenegger's proposals to fix the mess have been rejected by California voters, most recently on May 19. On June 16, Standard & Poor's put California's credit rating—already the lowest among states—on watch for a downgrade.

Golden State residents are all too aware of the cuts in essential services that may result, or that some businesses or taxpayers may have to accept IOUs as payment from the state. But will the rest of the U.S. have to share California's pain?

In May, State Treasurer Bill Lockyer sent a letter to U.S. Treasury Secretary Tim Geithner urging him to consider helping cash-strapped municipalities. The pitch by Lockyer and other California Democrats is a play on the "too big to fail" argument made on behalf of bank bailouts: If you don't save this bank (or in this case, state), the financial markets and the national economy will be thrown into turmoil. "This matters for the U.S., not just for California," Representative Zoe Lofgren (D-Calif.), who chairs the state's Democratic congressional delegation, told The Washington Post. "I can't speak for the President, but when you've got the eighth biggest economy in the world sitting as one of your 50 states, it's hard to see how the country recovers if that state does not."

The Obama Administration is now seeking to answer that question. So far the Administration has declined to bail out California. At a June 16 press briefing, White House spokesman Robert Gibbs underscored that stance, saying California's budgetary problem "unfortunately is one that [the state is] going to have to solve."

Governor Isn't Asking for Help

Later, in the evening, Republican Governor Schwarzenegger issued a statement denying he was seeking any such help. "We are in complete agreement with the White House that California should be solving its budgetary problems on its own without a bailout from the federal government," said the statement issued by Communications Director Matt David.

But there remains concern that the deeper California's woes get, the more it will delay the potential U.S. recovery. A report released by the University of California at Los Angeles on Tuesday projects the $24 billion annual state budget deficit will translate into 60,000 job losses by the middle of 2010. At the same time, the state could institute massive cuts in public services such as its welfare program, which serves 1.3 million people. The worry is that these efforts to balance California's state budget would work in a direct cross-purpose with the $787 billion U.S. stimulus package Obama signed in February.

Though few experts think California will default on its debt—following the example New York City set in 1975 and Cleveland in 1978—the mere possibility is troubling for the credit markets. "If California truly defaults, I am sure it will shake the faith of bondholders and noteholders in the overall municipal finance system," says Don Boyd, senior fellow at the Rockefeller Institute of Government. "That would undoubtedly lead to higher issuance costs to additional state and local government loans."

The Bond Perspective

Investors in the municipal bond industry are monitoring the situation. "California is one of the largest states in the municipal bond market, so we have to follow it and make sure we get the call right as an investor," says Hugh McGuirk, head of municipal bond investments for T. Rowe Price (TROW), an investment firm.

California is not alone in its fiscal misery. All but three U.S. states face budget gaps in the 2010 and 2011 fiscal years, with a collective shortfall of $350 billion, according to the Center on Budget & Policy Priorities, a Washington-based nonprofit. Michigan, whose economy was among the country's weakest even before the bankruptcies of General Motors and Chrysler, has also asked Washington for help. Treasury officials are considering helping the state's auto suppliers stay afloat to prevent mass layoffs.

While California is a huge state, some economists believe the harshest shocks from its distress may be confined to its borders. A hit to the technology or entertainment industry would be worse, economically speaking, for the rest of the U.S. than losses of state jobs for California services such as schools, universities, and hospitals, they say. "Losing private-sector jobs in export industries that drive the state's economy has more of a contagion effect," says Richard Ciccarone, managing director of McDonnell Investment Management in Chicago. "[Loss of] government workers have an impact, but the multiplier effect is not as big as in other industries."

Nearby states also would undoubtedly feel some pain. "The [economic] connection is not that strong unless you're talking about neighboring states with a trade connection like Nevada and Arizona," says Rajeev Dhawan, director of Georgia State University's Robinson College of Business. For example, Las Vegas would suffer if Los Angelinos make fewer trips to the city. "The further from California the state is, the less directly affected it will likely be."

Still, Boyd says that a default by California or any other state—or even severe spending cuts to balance their budgets—would take considerable stimulus out of the U.S. economy when it can least afford it. He says that state and local economies are pro-cyclical, meaning they are exacerbating the downturn even as the federal government pumps money into the economy. "States are raising taxes and cutting spending, while the feds are trying to achieve exactly the opposite."

Says Dhawan: "The fiscal landscape at the state and local level is more brutal than at the federal level, where you hear talk of 'green shoots' emerging. The exterior paint may look O.K., but the inside of the house is crumbling."

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