Greece as preview for California

MAY 3, 2010

By CHRISS STREET

Californians should pay close attention to the painful consequences to the Greeks from the downgrade of their country’s credit rating to “junk.” As one of the smallest members of the European Union (EU), representing only 2.5 percent of the EU economy, little Greece is being forced by its big brothers to accept a crash diet of wage cuts, high taxes and slashing spending. With California representing 13 percent of the U.S. economy and expecting a debt rating cut to junk this fall, who will bail out the State of California and at what cost?

California and Greece have much in common. Strong construction activity, real estate markets and consumer spending produced growth rates of 3 percent, twice as high as their neighbors. Both lost a substantial amount of manufacturing due to high taxes and an onerous regulatory environment. Both have high double-digit budget deficits, huge unfunded pension liabilities and cannot print their own money. Both maintained their lifestyles by borrowing as much money as they could get.

The Greek credit rating downgrade has sent their cost of borrowing from where California’s is today at 5 percent, to over 20 percent. At a 5 percent interest rate, the cost of debt doubles every 15 years. At a 20 percent interest rate, the debt doubles in less than four yeras.

To secure the bailout from their European Union big brothers, Greece is being required to implement tough spending cuts and punishing tax increases. Public employee wages will be hit with an immediate 14 percent to 28 percent cut and a four-year freeze. The retirement age will increase by 10 years and other benefits will be cut by 8 percent. The value-added-tax (VAT) on all Greek sales will increase from 19 percent to 23 percent. Taxes on fuel, tobacco and alcohol will increase by another 10 percent. The property tax and gambling taxes will increase and there will also be a one-time expropriation tax on whatever business is determined to be “highly profitable.”

This “tough love” Greece’s brothers are demanding as lenders appears to have a low probability of resulting in the loans ever being paid off. The economic projections developed by the lenders estimates that the Greek budget deficit will, according to New York market analyst Tyler Durden, fall from: “13.6 precent of GDP [gross domestic product] last year to 8.1 percent of GDP this year, to 7.6 percent in 2011, to 6.5 percent in 2012, 4.9 percent in 2013 and to 2.6 percent by 2014; all under the assumption that GDP will contract by 4.0 percent this year, followed by -2.6 percent next year, and then stage positive growth of +1.1 percent in 2012 and +2.1 percent in each of 2013 and 2014. If so, public debt to GDP will peak in 2013 at 149.1 percent, and decline to 144.3 percent in 2014.”

Given the combination that even liberal Keynesian economists accept that tax increases cut growth and Europe has only grown by less than 1 percent compounded over the last ten years, Greece returning to strong growth in two years seems whimsical at best.

What does seem very credible in the projections is that the Greek debt burden will rise from 133 percent of GDP to 149 percent in two years. Even if Greece can confound economics by returning to sustainable growth after raising spectacularly raising taxes, Greek debt is still going up.

California has only a matter of months before the combination of a recession, high unemployment costs and dysfunctional government dooms the credit rating of the state to fall junk. The voters thoroughly beat down efforts to raise taxes, so the only viable alternative for California to avoid a Greek-type default is implementing meaningful spending cuts and terminating anti-business regulation immediately.

Greece has always been smaller and poorer than its EU brothers, yet the tough love about to be inflicted on the country will be brutal. California has always been the biggest and richest state in the U.S., any bailout from its poor little brothers is going to be the “toughest love.”

Chriss Street is Orange County treasurer-tax collector.