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Mallory Factor: Debt Crisis In Paradise

by Mallory Factor

What leading vacation destination has a warm, temperate climate, villas overlooking the sea, terrific food and drink, and an enormous debt crisis? Greece has been in the news recently because its massive debt is sparking a crisis in the European Union. But I was actually referring to California.

While Greece dominates the headlines, California’s state debt is actually rated as more risky than Greek debt by at least two rating agencies. Although the rating agencies differ in their assessments of Greece and California, Moody’s rating agency gives California a Baa1 while it gives Greece a higher rating—A2. Don’t be mistaken: both ratings are severe warnings from the financial markets to California and Greece that they must get their fiscal house in order. The recent downgrades in California’s debt ratings mean that the state will face much higher costs of borrowing both now and in the future. Similarly, even though both have the euro as their currency, Greece’s borrowing costs are twice that of Germany because of the difference in the two nations’ perceived creditworthiness. And both Greece and California face similar problems attracting lenders to purchase their debt.

In the bond markets, Greece is known as one of the “PIIGS” – Portugal, Ireland, Italy, Greece, and Spain – countries that joined the euro in 1999 and have faced problems in adjusting and adhering to the strict economic discipline theoretically required of members. These problems may result from the economic union of weaker nations like the PIIGS with fiscally stronger nations like France, Germany, and the Netherlands. Right now, Greece is creating a problem for the European Union (EU). Greece’s national debt compared with the size of its economy, GDP, far exceeds the 60% ratio that is the limit for EU member states to adopt the euro as their currency. It is surprising that our fiscal status has declined so much in recent years that even if the United States wanted to adopt the euro, our federal debt to GDP ratio does not even come close to meeting the minimum criteria.

In the case of Greece, the EU has developed a plan to restore confidence in Greek debt and bring down Greece’s high borrowing costs. Under this plan, the 16 eurozone countries would be the lenders of last resort to Greece with support from the International Monetary Fund if necessary. To achieve this credit support, Greece needs to satisfy many conditions set forth by the EU and to adopt fiscally sound policies. Greece’s EU partners and the entire international community through the IMF have come to its aid. But who will step in to help California?

The only backstop on California’s debt will be us – or rather, the U.S, Uncle Sam. California is not a sovereign country, so it cannot have its own monetary policy; monetary policy is the responsibility of our Federal Reserve. But if the whole country becomes responsible for California’s – or any state’s – debt, that state will affect U.S. monetary policy. If the US backs California’s debt (and why stop at California?), the total federal debt would effectively rise.

And once Congress gets started down this path of bailing out a state, what incentive does any state have to balance its budget and behave in a fiscally responsible way? We’d be left with what might be termed “the mother of all moral hazards” – hundreds of billions of dollars in state debt taken on by the federal government, and further harming our own creditworthiness as a nation.

This year California has really backed itself into a corner, as it tries to close a projected $42 billion budget gap—in a recession and with declining state revenues. But unfortunately California is not alone. New York was recently ranked 49th of the 50 states in state debt problems. New York’s state-funded debt is an estimated 60.4 billion for 2009-10 fiscal year—which is far greater than its projected state tax revenues of $55.7 billion for the same period. This doesn’t even include county or local debt or unfunded future liabilities. And New York’s debt to revenue ratio is expected to worsen in 2010.

In Greece, the dramatic debt situation has led to calls for austerity, including ideas such as raising the retirement age and cutting the wages of public servants. This, in turn, has led to civil unrest, strikes and protests. What will it take for California, New York, and other states to get serious about their fiscal condition–not to mention future obligations coming down the pike such as their billions and billions of dollars in unfunded future pension liabilities?

At the height of the Greek crisis, one German Member of Parliament suggested that Greece might want to sell some islands to be able to finance its debt. If California and the other states with serious fiscal imbalances do nothing, could we someday be thinking about selling California landmarks like the Golden Gate Bridge to China?