California’s Debt Bubble: How Does It End?

In a January 2017 study we estimated that California state and local governments owe $1.3 trillion as of June 30, 2015. Our analysis was based on a review of federal, state and local financial disclosures. This debt equals about 52% of California’s Gross State Product of $2.5 trillion and does not include the substantial cost of deferred maintenance and needed upgrades to the state’s infrastructure.

This analysis begs the questions:

• How much debt is too much debt?

• How and when does it end?

How much debt is too much?  It’s hard to answer with the information available to us. It could take a long time to reach a crisis, perhaps many years or even a decade or more.  Who knows? There isn’t any hard stop or red line limiting California’s indebtedness.

If the economy is growing, debt can increase indefinitely if debt service costs aren’t growing faster than the economy. Government debt need not be paid off.  It is rolled over into new debt when it comes due. Governments don’t retire or go out of business so their debt doesn’t have to be retired.  The main costs are interest on the debt, required pension contributions, and increasing retiree healthcare costs.

On the way up, adding to debt is painless and allows politicians to spend more than current tax revenues can support, knowing that the cost of the debt is someone else’s problem in the future.  It can make sense to borrow to finance cost-effective infrastructure with a long useful public purpose.  But, borrowing can also be used to pay for current expenses or to fund white elephants such as the bullet train.

What is fairly certain:

1. Some other states such as Illinois could be an early warning sign for California in that they will get into trouble sooner. We can see what happens there and perhaps learn something. The Commonwealth of Puerto Rico which defaulted last year and which is now controlled by a federally appointed oversight board provides an even starker warning of the risks we face.

2. We are unlikely to have a state-wide crisis. We are more likely to have increasing problems in individual cities, counties, school districts and special districts. The financially weakest agencies will run out of options and get in trouble first. During the last five years, we have seen bankruptcy filings by the cites of San Bernardino and Stockton and by healthcare districts in Contra Costa and Sonoma Counties. Several school districts are operating under state oversight due to poor finances.

3. Underfunded pension funds will not be bailed out.  The state can’t afford to bail out individual cities, counties, and school districts that can’t pay interest on their debt or make required pension and OPEB payments.  The federal government will not bail out the state.  It would cost too much and would set a precedent that would have to be applied to other states that got into trouble.  Moody’s estimates that total state pension unfunded liabilities are $1.75 trillion at the end of fiscal year 2016. In fiscal year 2016 these pension funds earned a median return of 0.52 percent on investment compared to an average assumed rate of return of 7.5 percent.

4. It’s unlikely that the governor and legislature will take meaningful action until there is a crisis of some sort that gives the state no choice but to deal with the problem. Short of a crisis, politicians are likely to nibble around the edges to say that the problem is being addressed while avoiding any hard decisions.

How can pensions become a problem?  Aren’t pensions guaranteed by the California constitution?  Yes.  But, what does the constitution say to do if there isn’t enough money?  If a city or county goes bankrupt, federal bankruptcy law overrides the state constitution and allows but does not require pension benefits to be renegotiated in a bankruptcy.

So, how could it end?  Some possibilities are:

1. A slow death.  Required pension payments, retired public employee health care expenses, and interest on government debt grow faster than tax revenues.  Services are cut, head count is reduced, and maintenance is deferred to make interest, pension, and retiree health care payments. This is already happening.  An increasing number of cities, counties, and special districts would go bankrupt over time.  More school districts would be taken over by the state. A slow death could also involve CalPERS and other California pension funds continuing to earn less than their investment targets.  Pension funding ratios deteriorate and required pension contributions increase until the process spirals out of control.

2. A precipitating event. A recession or major stock market correction could cause a sudden reduction in tax revenue or significant pension fund losses that sharply increase underfunding.  In 2009, the CalPERS investment portfolio lost about 24 percent of its value.  California pension fund assets are heavily invested in stocks and other volatile assets that would lose value in a recession or stock market correction.  The result could be a forced recognition that future pension payments can’t be met in full.

3. Government employees get nervous.  California pension funds are paying out in benefits to retired government employees more than they are taking in in new contributions. In fiscal year 2015, they paid out $1.40 in benefits for every dollar they received in contributions.  Think about it!  If you are a working government employee, none of the pension payments made on your behalf go into an account with your name on it. Your pension is totally dependent upon pension fund investment performance and the willingness and ability of future taxpayers to cut expenses and raise taxes to cover any shortfall in fund performance. In the future, will taxpayers and the politicians who represent them be willing to do whatever it takes to pay unfunded pension and retiree health care expenses?  Will they be more interested in finding ways to reduce these expenses?  Will there be enough tax money to go around even if their intent is to honor these unfunded obligations and other debts?

So, how and when does it end?  We can’t be sure?  However, it could end badly.