California: The Frog in the Sub-Prime Frying Pan

Just as a frog will jump out of a hot frying pan, but will sit in water that slowly goes from cold to hot until he cooks to death; California’s politicians have sat quietly as the accumulation of chronic budget deficits bubbling up from an uncomfortably warm problem to a scalding hot crisis. Even the release of Governor Schwarzenegger’s $19.1 billion budget deficit projection for the coming July fiscal year appears to have failed to bludgeon the state’s political establishment into action to avoid a looming credit rating downgrade to sub-prime that would set off a Greek style default on steroids.

The media, after months of missing the potential consequences of a Greek default, have now become focused on the similarities between California and Greece. Both do owe gobs of money, have huge budget deficits, massive unfunded pension liabilities and can’t print their own money; but California’s situation is worse! The California economy is 5 times larger than the Greek economy. Los Angeles alone is twice the size of the $356 billion Greek economy. Greece is less than 2.5% of the European Union (EU) economy, but California is over 13% of the US economy. From 2000 to 2008, the Greek economy grew at 3.1% annually, the second fastest growth in Europe, whereas California’s growth of 2.3% during the same period was only slightly better than the rest of the US. Greek unemployment just hit a crisis 12.1%, unemployment in California is 13% and has been above Greece’s since the start of the year.

What started out a month ago with Greece having trouble making a $10 billion debt payment has mushroomed into a worldwide liquidity crisis. Germany and France have been forced to lead a $1 trillion bailout. Even the U.S. was required to kick in $50 billion to the support International Monetary Fund’s contribution. For a few days this block-buster financial backstop calmed the bond markets and allowed short-term interest rates across Europe to decline, but by the end of the week Greek interest rates were headed back up.

Chief Executive Josef Ackermann of Deutsche Bank, Germany’s largest financial institution, said last week he was “doubtful whether Greece will really be in a position to achieve” the repayment of the emergency loans. However, he went on to stress that Athens had to be propped up, because if it fell, it would lead “with great certainty to a spillover to other countries,” sparking “a type of meltdown,” he added. Ackermann’s comments are all the more surprising because they follow recent reports that Deutsche Bank itself is preparing to provide €500 million ($625 million) in loans to Greece on the same conditions as those set by the German government.

Last September the state of California sold $8.8 billion of prime rated short term debt to investors at an interest cost of 3%, similar to rates Greece was paying before the threat of default sent the rate to 24%. The Governor Schwarzenegger’s new budget projections indicate that California will need to borrow $12-15 billion just to get through the fall. Given that state’s economy is five times larger than Greece, if California is downgraded to sub-prime this fall and the crisis spreads to municipalities and other states, it might take up to a $5 trillion bailout to stabilize the situation.

The world would expect the U.S. Government to provide an American solution for a California debt crisis. But unlike Germany and France, who as the largest member states in the European Union were politically forced to shoulder the majority of the $1 trillion bailout of little Greece, expecting the America’s smaller states to have the political will and the financial wherewithal to bailout giant California is much more problematic.

The International Monetary Fund estimated the ratio of the United States national debt to Gross Domestic Product was 82% versus Greece at 115% as of last year. A $5 trillion American led bailout would immediately push the U.S. ratio to Greek levels. With all the losses the U.S. banks are suffering from real estate foreclosures, they have no capacity to aid in the bailout the U.S. federal government.

There is precious little time for their own survival for California’s political establishment to come together on a program of at least $15 billion of spending cuts to offset the state’s cash shortfall. German Chancellor Angela Merkel’s Christian Democratic Party just lost an election for control of the upper house of Germany‘s Parliament last week as voters punished her party for making Germans have to pay for what they see as Greek irresponsibility and political corruption.

Voters across the nation are becoming increasingly frightened by the rising U.S. national debt. If California continues the status quo and finds itself on the verge of default this summer, their fellow Americans might just demand that the state suffer the full consequences of their deficit spending ways. Unfortunately for the world economy, a sovereign default by an entity the size of California could set off a massive liquidity crisis and push the world’s economy into another deep recession or worse.