California’s day of reckoning is a warning for Europe

California ‘IS’ broke and the US ‘IS’ broke too.

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California is the salad bowl in which the world serves up its more exotic lifestyle experiments. Mix sunshine with self-indulgence and dress it with surf-wear and you get a glimpse of how we might live in the future – if we could only afford the plastic surgery.

Unfortunately, it appears that even Californians can no longer afford the lifestyle of the Valley Girl.

The Golden State is almost bust, but its inhabitants, even if they believe it, do not want to know and they certainly do not want to pay for it. The state has been running huge budget deficits for years; the till in Sacramento, the state capital, is now empty and the last-ditch attempt by Arnold Schwarzenegger, the Governor, to balance the books with a series of tax increases and budgetary shuffles was roundly rejected by voters in referendums a week ago.

With a $21 billion (£13 billion) deficit and the lowest credit rating of any American state, the choices are few and grim. California cannot hope to borrow such large sums, except at extortionate rates, which leaves the option of massive cuts in public spending – the sacking of thousands of teachers.

California could run out of cash in a few months. Mr Schwarzenegger has already warned that 5,000 state employees face being fired. The state education budget is in line for a $5 billion cut, alongside the end of funding for parks and the closure of at least one state agency.

Meanwhile, there is talk of a trip to Washington to seek financial assistance. One idea is a federal guarantee of short-dated bonds issued by Calfornia, but that solution would be resolutely opposed in Congress by states resentful of West Coast profligacy. One of President Obama’s early constitutional headaches may be getting the financial bailout of California approved by Congress.

Inevitably, the Golden State’s excesses will have to be curtailed. What will jealous legislators from other states demand in return for more cash for the beach bums? The fight will be ugly and California may find that it is not only its extravagant lifestyle that is in the straitjacket, but its political freedom as well.

Politicians in Europe will be watching the Californian car crash with fascination and horror. The sight of the world’s favourite American state lurching towards financial Armageddon is not unlike watching an episode of the American television drama Desperate Housewives. You laugh at the outrageous behaviour of the characters, believing that your neighbours could never behave in such an appalling way, until, on reflection, you wonder . . . On Europe’s eastern fringe, there is Hungary, a financial basket-case, its banking system crippled by a private borrowing binge in Swiss francs. Hungary is already supported by the IMF and the European Union has resisted calls for a regional financial rescue package for the former communist states, but even within the eurozone, the financial stress is mounting in Greece, the Irish Republic, Italy and Spain.

Were a eurozone government to find itself at risk of being unable to pay interest on its sovereign debt, there is no question that fellow member states would have to provide financial support to prevent default. The alternative would be for that state to abandon the euro, float its own currency and allow its economy to implode in what could be rapid devaluation and, ultimately, bankruptcy.

It is the Argentine scenario, scary stuff, but if America is looking at a financial rescue package for California, the EU must begin to contemplate similar tailspin scenarios for its more precarious member states. Sterling and the gilt market suffered a rude shock last week when Standard & Poor’s, the credit rating agency, gave warning that Britain could lose its AAA rating if government debt rose to a level equal to the country’s gross domestic product.

Standard & Poor’s was doing nothing more than casting doubt on the conservatism of forecasts of economic growth and tax revenue published by Alistair Darling, the Chancellor. If S&P’s more gloomy outlook is correct (and the April public borrowing figures were worryingly high), the Government will be forced to borrow much more or to make drastic cuts in public services.

Britain already needs to borrow a staggering £220 billion this year to pay the bills. Without the triple-A rating, the cost of borrowing will soar and the attractiveness of UK government paper will diminish. Britain is not yet heading down the highway to California’s world of sun, sand and insolvency, but even if the Chancellor still clings to the validity of his own Budget projections, he needs to begin thinking about the other side of the California equation if he plans to be residing in No 11 Downing Street next year.

If S&P is right and Mr Darling wants to avoid dumping second-rate British wallpaper into the bond market, he must raise taxes or implement Mr Schwarzenegger’s threat: a bonfire of public service jobs, cutting GPs’ salaries and closing a government department.

There is an alternative to putting the bloated public sector on a crash diet, because Mr Darling, unlike Mr Schwarzenegger, can impose tax increases without a referendum. However, he should look carefully at the message that emerged from California’s exercise in fiscal democracy. Roughly two thirds of voters rejected every tax-raising measure put before them. The only proposal to gain approval was one to bar pay rises for state officals who run up deficits – a measure that secured 74 per cent of votes in favour, evidence of the growing tide of public resentment against taxes and government.

California’s absurd rule by referendum, in which the electorate can vote to spend public money without funding the expenditure with new taxes, is found wanting. However, our own system of sending politicians off with a cheque book so that they can engage in a spending spree for five, or even ten, years before they are kicked out, seems to be equally flawed.

There is an almost universal assumption that the next government, of whatever stripe, will be imposing new taxes to avoid a junk-bond future. This easy option should not be allowed to run its course without challenge, because it ignores the risk of turning Britain into a junk economy of high taxes and low growth. It is no coincidence that the pressure to bring tax havens to heel has become intense over the past six months. So panicked were the finance ministers of the G20 nations about the risk of capital flight from the grabbing State that a campaign of bullying was launched against a small group of nations that refuse to accept that the State has the power to achieve absolute dominion over private wealth.

Germany excelled itself, with Peer Steinbrück, the Finance Minister, suggesting that a whip should be used on the Swiss to fight tax evasion and bank secrecy. Franz Müntefering, the leader of Germany’s Social Democrats, said that “in the old times one would have sent in troops, to combat tax havens”.

Not surprisingly, Germany’s neighbours, notably Luxembourg, which has in the past played host to German troops, were not amused by Mr Müntefering’s remarks. It remains to be seen whether Europe’s taxpayers will be amused when the focus of this fiscal aggression begins to reach deep into their pockets.

May 26, 2009
Carl Mortished: Business commentary

Source: The Times