Lessons From the California Recall

It’s easy to dismiss last week’s California recall election as a spectacle, but that state’s financial problems are very similar to those all of us face because of the spendthrifts in Washington. The old saying “As California goes, so goes the nation,” might well mean the nation is following California down the road to bankruptcy.

The problem in California is easy to identify: the state government consistently spends more than collects in taxes.  Drunk on record revenues from the stock boom of the late 1990s, legislators in California went on a spending spree that bloated social services and added thousands of government employees to state payrolls.  Politically, social service programs and government jobs are easy to create- but virtually impossible to eliminate.  So when the bubble burst and tax revenues dropped dramatically, the state predictably kept spending at the same rate.  The result is record budget deficits and the potential for a default on payments to state employees, various creditors, and bondholders.

If the scenario on the west coast seems familiar, it’s because we’ve seen it before in Washington.  Congress spends far too much regardless of revenues.  The fundamental difference is that the State of California, unlike the federal government, cannot simply print money to pay its obligations.  It has only two choices when spending outpaces revenues: borrow money or raise taxes.  With its bond and credit ratings floundering, borrowing is a difficult and expensive venture.  Taxpayers in the state already pay some of the highest taxes in the nation, so tax hikes are politically unpopular.  Faced with this dilemma, California lawmakers did nothing, hoping to keep the treasury afloat until tax revenues rebounded.  But the economic turnaround never happened, so California faces a crisis here and now.  Somebody had to pay, and Gray Davis was the most visible symbol of an irresponsible government.

Federal politicians, however, can use government printing presses to sweep economic problems under the rug and hide the effects of deficit spending- at least for a time.  Our fiat monetary system permits politicians to spend money now to win votes and fund popular programs, while delaying the harms until later.  When the federal government monetizes debt by magically paying its bills with newly printed money, the economic effects are diffused throughout the economy.  Over time, however, we all pay for the increased number of dollars in circulation.  Prices go up, personal savings are eroded, and the dollar becomes weaker against other currencies.

The crisis in Sacramento should serve as a cautionary tale for all Americans.  Legislators in statehouses across the country and in Washington lack the political will to cut spending.  They consistently spend more each year, without regard to revenues.  If the process goes on too long, government becomes insolvent, unable to tax or borrow enough to satisfy its voracious appetite.  It could happen in your state, and it is happening in Washington.  It’s worse in DC, however, because Federal Reserve printing presses help our national politicians temporarily evade reality.  If Congress continues to spend and print dollars at the pace of recent years, however, the devaluation of our currency will make all of us poorer for decades to come.