Financial Reform Watch

California on the Cutting Edge

Occasionally, the FRW team ventures out to take the pulse of the country on key issues coming up. Based on several days talking to journalists, business leaders, and government officials in California, we bring to our readers words of caution: the fiscal meltdown in California holds no small dangers for the recovery.

When California voters on May 19th rejected the key elements of the budget deal which averted disaster earlier in the year, top officials in Sacramento were sent back to the drawing board for an approach that will stave off a budget gap of more than 15 percent. With observers of the legislature saying that tax cuts, program cuts, and layoffs are all non-starters, where lies the answer?

The emerging view in the not-so-Golden State is that the answer lies in Washington. The fact that Governor Schwarzenegger was in Washington on the day voters went to the polls to vote on the budget deal indicates where he believes his priorities lie at the moment.

One potential scenario would involve the state asking Washington, using TARP resources, to guarantee state bonds - thereby allowing the state to access credit markets at reasonable rates. Another approach being floated is a short-term federal loan. Having observed how the Obama team has managed its relations with banks and auto companies, one can project that such an action would bring with it a strong prescription from the White House that the state develop a plan for righting its ship with a combination of steps that today seem impossible.

One member of our team was involved in the federal bailout of New York City in the 1970's. At that time, the City came to the Government in two steps -- first in 1975 for short-term loans and second in 1978 for loan guarantees. Between those two events, the City cut its work force by almost 25 percent, doubled the subway fare, cut services and raised fees and got its pension funds to agree to buy a substantial amount of debt. We would not be surprised if Felix Rohatyn, the architect of the City's rescue, doesn't appear in the public square (or even the White House) soon to discuss how a California rescue might work, based on the New York example.

Is California too big to fail? One could argue whether it is from an economic standpoint. But in terms of politics, it may be less debatable. We are anticipating official Washington will be turning to this problem in the next few weeks. Stay tuned.

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