California's Economy: Too Big to Fail?

Despite a $24 billion budget deficit and a legislature in stalemate, California lawmakers haven't persuaded the Obama Administration to bail out the state

By Moira Herbst

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.

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