California is (still) sliding towards an insolvency event of some sort. Their budgetary and legislative issues are insurmountable. Making the drastic cuts necessary is a near impossibility, and jacking up taxes on the beaten-down public is equally untenable.

Now the WSJ reports that the Governator is seeking $6.9b in Federal funds. Arnold is threatening to slash welfare spending, medicaid, and other social programs (he has made similar threats before, as I noted in May ’09).

Try to imagine, for a second, what would happen if California halted welfare payments, or food stamps. It’s safe to say that things could escalate quickly.

From the WSJ (01/07/2009):

Republican Gov. Arnold Schwarzenegger asked for $6.9 billion in federal funds in his state-budget proposal Friday and warned that state health and welfare programs would be threatened without the emergency help.

Mr. Schwarzenegger’s proposed $82.9 billion general-fund budget for the 2010-11 fiscal year would close a $19.9 billion gap over 18 months. In addition to the federal aid, he called for $8.5 billion in cuts and $4.5 billion in alternative funding to balance the budget.

‘It’s time to enact long-term reforms that will change the way the most populous state and the federal government work together,’ Mr. Schwarzenegger said. He and state legislative leaders plan to visit Washington to lobby for bailout money. White House budget officials weren’t available for comment on the governor’s request.

Mr. Schwarzenegger said that without the federal aid, he would propose cutting $4.6 billion from state assistance programs and raise another $2.4 billion, largely by extending the suspension of tax breaks.

Default Inevitable?

The last time an American state defaulted on their debt was in the 1840′s, as Bill Watkins notes in What Happens When California Defaults? (must-read). Watkins, who has a Ph.D in economics from UC Santa Barbara, thinks default is the most likely outcome. Here are his thoughts on the fallout:

We’re left with the question: what happens when California defaults? The worst case would be the mother of all financial crises. According to the California State Treasurer’s office, California has over $68 billion in public debt, but the Sacramento Bee’s Dan Walters has tried to count total California public debt, including that of local municipalities, and his total reaches $500 billion. Whatever the amount, the impact of default could be larger than the debt amount would imply. Other states – New York, Illinois, New Jersey, for example – are in almost as bad shape as California, and they could follow California’s example.

The realization that a state could default would shock markets every bit as much as when Lehman Brothers failed. Given the precarious state of our economy and the financial sector, another fiscal crisis would be disastrous, with impacts far beyond California’s borders.

Watkins also weighs in on the orderly bankruptcy scenario (which he thinks is unlikely):

Ideally, we’d see a court-supervised, orderly bankruptcy similar to what we see when a company defaults. All creditors, including direct lenders, vendors, employees, pensioners, and more would share in the losses based on established precedent and law. Perhaps salaries would be reduced. Some programs could see significant changes. This is distressing, but it is better than other options.

Unfortunately, a formal bankruptcy is not the likely scenario. There is no provision for it in the law. Consequently, absent framework and rules of bankruptcy, the eventual default is likely to be very messy, contentious and political. [emphasis mine]

As Mr. Watkins says, this is the best option. Creditors and others who rely on state revenue are forced to take a haircut. It’s unfortunate that pensioners would be among the casualties. But California’s public sector is bloated, and something’s gotta give. Take the Northern Cali Fire Chief who retired with a $241k pension. It’s simply ludicrous.

The alternative scenario, in which the public eats the losses, is unacceptable (and all too familiar). The parties who funded and benefited from CA’s unsustainable spending have to take a hit. It is what it is.

As a nation, we need to prepare ourselves for a lower standard of living and start cleaning up our collective balance sheets. The next 10 years will be trying enough. If we project sunshine and rainbows, the reality is gonna be that much harsher when it does hit.

Cartoon by Steve Greenberg.