Inflation Means California Default

APRIL 29, 2011

By WAYNE LUSVARDI

A March 24 Los Angeles Times-USC opinion poll indicated that 80 percent of likely California voters favored putting a cap on state spending.

That is a remarkable statistic that didn’t make the original headline in the Times about the results of the poll.  Instead, the Times thought that what was a headline story was that 53 percent of survey respondents supported “tax hikes to help close budget gap,” when only 9 percent actually stated they favored tax increases.

Due to overwhelming negative online comments to the Times’ boosterism for tax hikes, the Times had to post a second story online with a different headline about how the major finding of the poll was that 80 percent of those surveyed favored a state spending cap much more strongly than they did a mixture of budget cuts and tax hikes to fix the state budget.

Despite the slant in the reporting of the USC poll, this raises the question: How would it be best to get out of the current bear trap the state finds itself in of looming inflationary bond interest rates on any new debt? And doing so while running continuing deficits that do nothing to address a coming $500 billion public pension Tsunami equating to about a $20 billion hit per year out of the state General Fund.

The current policy to close the pension funding gap is to gamble, just as Orange County Treasurer Bob Citron did in the mid-1990’s, that pension fund returns will always go up at compound rates of about 8 percent or higher — with no occasional dips.  Such a high-risk policy is based on a false upward linear trend of investment returns instead of the peaks and troughs of investment markets. Orange County’s policy led to bankruptcy.

California’s pension funds are shooting for the moon and Gov. Moonbeam is not alerting the public to the risks involved in yet another fall in the Cal-PERS pension fund.

But are the people right about a state-spending cap? Would it help or hurt?

Contra Dan Walters, Real Cal GDP Declined

Dan Walters, the dean of California newspaper journalists, has written that plugging the $20 to $25 billion structural budget deficit would amount to scarcely 1 percent of our Gross State Product of $1.9 trillion.

But what Walters is reporting is the face amount of state output, not the real output adjusted for monetary inflation.  If we look at an historical chart of the amount of the state’s real economic output, the Gross State Product grew about 30 percent in the last 10 years, or 3 percent per year.

But inflation measured by the Consumer’s Price Index averaged 3.2 percent per year. Discounting the current $1.9 trillion state GDP by the Consumer Price Index of 3 percent inflation per year indicates that real state output declined about 2 percent over the last 10 years.

Instead of using the Consumer Price Index, if we use the Producer’s Price Index (PPI), inflation was 4.8 percent per year over 10 years, which indicates an 18 percent decline in real state GDP (4.8 percent — 3.0 percent = 1.8 percent; then multiply that by 10 years and you get 18 percent).

The Producer Price Index is a measure of inflation for producers of finished wholesale goods, partially finished goods, and commodities. The Consumer Price Index is a measure of inflation of retail goods.  In other words, the CPI is a measure of inflation to the buyer and the PPI to the seller.  CPI means retail inflation and PPI means wholesale inflation.

If the 2010s look like the 2000s, and suffer a negative 2 percent to 18 percent state GDP “growth,” that would mean that real GDP would decline to $1.2 to $1.4 trillion. And if that happens, we would be right back to where we started before the housing bubble of the mid-2000s — or worse.

Dan Walters failed to perceive this when he only looked at the apparently rising GDP number of $19.1 trillion unadjusted for inflation.

However, economist John Mauldin in a recent article, “Get Ready for the ‘Miracle’ of Compound Inflation,” asked what would happen if GDP growth tracked at 4 percent and inflation tracked at 4 percent per year over the next 10 years?

Under such a scenario, the face level of GDP for the entire United States would be $30 trillion, double the current number for 2011. Mauldin calls this a “roaring economy, except gas would be $8 per gallon.”  Everything that cost $1 today would cost $2, and health costs would likely be even more. Your pay or pension income would have to double to keep pace. California’s middle class might be wiped out or would have to flee.

Inflation is another way to say default

To help you understand this, let’s say your household has gone on a spending binge made possible by easy money loans and you no longer have enough money to meet expenses.  So let’s say you start multiplying your own money supply by cutting dollar bills in half and giving the grocer, your mortgage lender and your credit card banker half of a dollar bill for each full dollar owed. You do that to pay for everything instead of going into foreclosure and bankruptcy.

In other words you need to make your insufficient number of dollars spread farther so you start asking everybody to take 50 cents on the dollar.

But — your grocer, mortgage lender and banker start doing the same thing in reverse. They now want four half-dollar bills, or $2, for every full dollar owed because they don’t know how much your half-cut dollar bills are worth.

That means the value of the dollar has been diluted. You need more and more dollars to keep up.

This is inflation. It is just another way of saying that you are in default on your loans.

As Mauldin states it:

Higher inflation means…debt is easier to pay back, as nominal GDP is what we pay taxes on, not inflation-adjusted. Inflation is a tried and true method of dealing with too much debt. Inflation is also just another word for default, but it sounds so much better to the ear.

Lockyer Technically Correct

So when State Treasurer Bill Lockyer assures state bondholders that the state won’t default on its interest payments, he is technically correct. But if you are a bondholder making 5 percent interest and inflation rises to, say, 6 percent, you are losing 1 percentage point in real terms.  The amount you invested in bonds is being plundered.

This is why the Average Citizen and the state keep talking past each other when it comes to the issue of whether the state is insolvent. The Average Citizen keeps charging that the state is bankrupt. And the state keeps saying it isn’t.

What the state doesn’t tell you is that its policy is just to inflate its way out of default by paying off its debts in cheaper dollars.  Since California can’t print money like the federal government, it is going to inflate the wholesale price of everything by increasing electricity rates for Green Power, tacking a pollution tax on everything under what is called cap-and-trade regulations from AB 32, and inducing wet-droughts that pump up water rates.

All under the guise of global warming. Global warming is a euphemism for monetary inflation, but not inflating temperatures.

Citizens Support Spending Freeze

So the Average Citizen’s overwhelming support for a state spending cap is a viable solution to the state budget and bond crises. The Average Citizen has a better hunch about what would work than do the elites who put out booster opinion polls for higher taxes and California’s great weather.

This is probably because Californians know what works in managing their household finances when money gets tight. But don’t expect Gov. Moonbeam and his legislative lunar modules to freeze anything in a state impacted by “global warming.”