California is Too Big To Fail; Therefore, It Will Fail

Bill Watkins
Executive Director of the Center for Economic Research and Forecasting at California Lutheran University

Cross-posted at

Back in December I wrote a piece
where I stated that California was likely to default on its
obligations. Let’s say the state’s leaders were less than pleased.
California Treasurer Bill Lockyer’s office asserted that I knew
"nothing about California bonds, or the risk the State will default on
its payments." My assessment, they asserted, "is nothing more than
irresponsible fear-mongering with no basis in reality, only roots in
ignorance. Since it issued its first bond, California has never, not
once, defaulted on a bond payment."

For good measure they labeled as "ludicrous" my comment that the
Governor and Legislature may not be able to solve the budget problem
next year because "debt service is subject to continuous appropriation.
That means we don’t even need a budget to make debt service payments."

The Department of Finance was also not amused. They resented my
prediction that California is on the verge of a default of its bond
debt. They insisted that the state has

"multiple times more cash coverage than we need to make our debt service payments."

"There are three fail-safe mechanisms in place to ensure that debt service payments are made in full and on schedule."

"Going back as far as the Great Depression, California has never —
ever — missed a scheduled payment to a bondholder or a noteholder. Not
during the recession of the early 1980s. Not during the collapse of the
defense industry in the early 1990s. Not during the dot-com collapse of
the early 2000s. And not now. And we, along with the Treasurer and the
Controller, will continue to ensure that this streak will never be

I am not alone in being taken to the state woodshed. More recently,
Lloyd C. Blankfein, Chairman of the Board and CEO of Goldman, Sachs
& Co. received this letter from Lockyer’s office, a letter that was ridiculed by The Financial Times’ Spencer Jacob here.

Once you get past the name calling, California has two arguments.
One argument is that California has never defaulted; therefore it will
never default. This is, of course, absolutely absurd, insulting our
intelligence. Every person, corporation or other entity that has ever
defaulted on a loan has been able to say, at least once, that they have
never defaulted. As they say in finance: Past performance is not a
guarantee of future performance.

California’s second argument is that it has both a constitutional
requirement to meet certain debt payments and the cash to do so.

That’s nice.

I have no idea what a constitutional requirement to meet debt
payment means, but it doesn’t mean that California will always pay its
bills. California has a constitutional requirement to have a balanced
budget every June. That constitutional requirement is ignored almost
every year. It was ignored last year. It will be ignored this year. It
will be ignored next year, unless the Feds have bailed out California,
relegating the state’s legislature to rubber-stamp status.

California’s constitutional requirement to meet debt payments will
mean nothing when the state’s financial crisis comes. It won’t mean
anything if a debt issue or rollover can’t be sold. It won’t mean
anything if the state has no cash, and banks refuse to honor
California’s vouchers.

The relevant analysis begins with the recognition that California is too big to fail, which means it will fail.

Since there is no procedure for a state to file bankruptcy, the
solution to California’s financial crisis will be chaotic. What does it
look like when the government of the world’s eighth largest economy
can’t pay its employees, or pay its suppliers, or meet its obligations
to school districts, counties, cities or other local government

It looks ugly, ugly enough to have huge economic ramifications far
beyond California’s borders. It looks ugly enough to mean that
California is too big to fail, and that’s why we will have a financial

Once something (a bank, a car manufacturer, a state) is too big to
fail it has perverse incentives. A moral hazard is created because of
the free insurance. In California’s case, the moral hazard is
exacerbated by a system that assigns responsibility to no one. The
super-majority requirement means that both parties will escape blame,
and the required cooperation of the legislature will absolve the
governor. The governor will blame the legislature. The Republicans will
blame the Democrats. The Democrats will blame the Republicans. The
citizens will blame the political class. Talking heads will blame an
allegedly fickle electorate. Everyone will point fingers, but the blame
will not settle on anyone.

In the end, blame will not matter. No one in a position of power in
California has the incentive to make the tough decisions needed to
avoid a crisis. So, no one will. Indeed, at this point everyone has an
incentive to not make any hard decisions. A bailout from the Feds will
be a wealth transfer from the citizens of other states to California’s
citizens. The incentive is to drag things out, to appear to be working
on the problem, to maximize the eventual windfall.

I’d love to see California’s political class show some leadership,
step up, and effectively deal with the state’s financial problems, but
that really is unlikely, requiring as it will, tough decisions on
spending priorities and taxes and foregoing a windfall. Ultimately,
money usually trumps character.

Bill Watkins is a professor at California Lutheran University
and runs the Center for Economic Research and Forecasting, which can be
found at

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