California Dreaming

Moisés Naím, Uri Dadush and Bennett Stancil / Carnegie Endowment for International Peace

With the debt crisis in Europe now entering its second phase, California seems an odd place to turn for guidance. At first glance, California appears to be in the midst of an economic and fiscal crisis that dwarfs Europe's. Its unemployment rate, now more than 12 percent, is one of the highest in the United States and nearly 3 percent more than the EU average; California's home prices have dropped 34 percent since 2007, while in Europe the decline has been moderate; and, over the last three years, the collapse of California's tax receipts produced a cumulative budget deficit of about 40 percent of its revenues, more than twice that of Greece. California's politics are as gridlocked as any in Europe. Political infighting left the state without a budget for the first 100 days of this year.

Despite this grim picture, however, Europe has reason to envy California. Financial markets are treating the state—whose economy is larger than that of most Euro area countries, including Spain—far more leniently than they treat Europe's debt-stricken countries. California's debt trades at spreads less than 1 percent higher than those of AAA states, whereas the bonds of Greece, Ireland, Italy, Portugal, and Spain (GIIPS) trade at an average 4.5 percent spread vis-à-vis Germany.

How has California retained the market confidence that several countries in Europe have lost, despite similarly bursting budgets and economic shocks? As a U.S. state, California benefits from a more resilient institutional design that enables it to emerge from its crisis stronger and faster than Europe's worst fiscal performers. When rethinking the institutional arrangements that underpin their monetary union, countries in the Euro area can learn from the experience of America's Golden State.

GOVERNMENT DEFICITS

The immediate cause of Europe’s recent crisis was the surge in public-sector deficits and the corresponding rise in government debts, which now represent roughly 100 percent of GDP in the GIIPS.  In California, debt is less than 5 percent of GDP. This is possible because federal spending accounts for about 55 percent of all public expenditures in California and autonomous municipalities account for another 25 percent; therefore, the state is responsible for only a small portion of public services and annual state spending amounts to approximately 8 percent of its GDP. (Even relative to the size of its operations, California’s state government is in sounder fiscal shape than Europe’s periphery: debt represents roughly 80 percent of annual revenue, compared to an average of 200 percent in the GIIPS.) In Europe, national spending typically represents about 50 percent of GDP while the budget of the European Commission—the closest analog to a European federal government—accounts for just 1 percent.

Moreover, the federal system has helped absorb the shock caused by Great Recession. By indirectly transferring funds from better- to worse-performing regions and by being able to borrow easily and cheaply, the U.S. government ensured that the safety nets available to Californians continued to operate throughout the crisis even as its residents contributed less to them. For example, in 2006, California contributed $5.3 billion in taxes for unemployment insurance, and received $1.2 billion in benefits; in 2009, California’s contribution fell to $4.7 billion, but benefits more than doubled to $2.5 billion. These added benefits, despite the fall in revenue, helped moderate the shock in California without straining state coffers. Europe's decentralized fiscal system guarantees no such stability.

California’s own laws also helped prevent debt from spiraling out of control. Like most states, California is legally obligated to pass a balanced budget. The Financial Stability Pact, Europe's closest equivalent, does not have the same force of law, and has been repeatedly and spectacularly flouted.

Finally, in the United States, no legal procedure exists to deal with the default of a state (it has not happened in the union's 234 years), but financial markets expect that the federal government would handle the process much like it has handled about 500 municipal bankruptcies, which are managed through Chapter 9 of the bankruptcy code. If a European country defaulted, there is at present complete uncertainty about who would be in charge or how creditors would be treated, which makes the risk all the more unattractive.

COMPETITIVENESS AND FLEXIBILITY

Though the surge in deficits catalyzed the crisis, the deeper roots of Europe's woes lie in the loss of competitiveness of the GIIPS relative to Germany and the European core. Labor costs in Italy and Greece, for example, have risen by more than 25 percent relative to Germany’s since they adopted the euro a decade ago.

In California, this has not happened; prices and wages there have moved roughly in line with those of the rest of the United States. Since 2000, California’s consumer prices have risen 33 percent, compared with an increase of 29.3 percent in the United States.

Labor market flexibility also helped cushion the fall in California. Employers can more easily reduce payrolls in a downturn, and wages adjust more rapidly. Moreover, economic and cultural factors allow U.S. workers to move more fluidly across state lines than Europeans do across country borders, adding yet another shock absorber. Between 2008 and 2009, 1.5 percent of the U.S. population moved to a different state. Though this is down from an annual rate of between 2 and 2.5 percent before the crisis, it is considerably higher than cross-border moves within the EU, which was estimated to be only 0.1 percent annually in the middle of the decade.

Partly because both workers and firms are exposed to more competition and partly because of this labor market flexibility, American firms have restructured faster: U.S. GDP is currently only 0.7 percent below its level in the second quarter of 2008, while output in Europe is down by 2.8 percent. Meanwhile, since bottoming out in the second quarter of 2009, investment in the United States grew by 23 percent through the second quarter of this year, compared to a rise of 8 percent in the EU.

LEARNING CALIFORNIA’S LESSONS

Despite these relative advantages, California faces an uphill climb. Unless revenues rebound quickly, California must make steep cuts to close the state’s budget gap, which is predicted to be $19 billion in the next fiscal year. This challenge will be made even more difficult as newly elected federal legislators look to cut spending, including aid to states.

Nevertheless, financial markets are once again bearing down on Europe while California has retained their confidence, largely because of its status as a U.S. state. Though a U.S.–like political union is not imaginable for Europe, the continent can replicate some of the institutional arrangements that allowed California to weather the storm better than many European countries.

First, California's experience suggests that, in a monetary union, being part of a much larger entity that maintains a AAA rating and controls the currency reassures financial markets. To be sure, a more fiscally centralized Euro area would mean spreading around countries’ debts and risks: reinforcing especially hard-hit countries would come at the expense of those that are better off financially.

However, increasing the funds available to stricken regions would help prevent asymmetric shocks from destabilizing the continent. Indeed, transfers of this kind would be fraught with political challenges, though these could be alleviated if they were activated automatically and supported commonly shared European objectives—such as an expanded EU program to help provide basic unemployment insurance.

Second, establishing a process through which debts can be restructured—such as Chapter 9 in the United States—would benefit all countries in Europe. If, for example, fiscal transfers were tied to stricter enforcement of the Financial Stability Pact, Germany as well as Greece may be inclined to support it. The recent German proposal to establish a resolution mechanism for sovereign debt makes a move in this direction.

Markets greeted the official recognition of the possibility of default by a European country with consternation. Given the yields they are demanding to lend to distressed nations, this may appear surprising. Nevertheless, it is probable that, if and when such a mechanism is established, it is more likely to reassure lenders than to deter them. 

Third, improving labor market flexibility could help repair the competitive imbalances that now make solving the Euro crisis so challenging. Not only do rigidities within and across countries prevent firms from reorganizing as quickly as possible and curtail business investment, they also make the necessary labor cost adjustment in the GIIPS slow and difficult.

Some of these measures, such as the permanent rescue fund, are now being vigorously debated by EU leaders. These reforms will not make Europe immune to future economic shocks, but they will both help minimize the economic and political fraying that they cause and prevent today’s crisis from causing more pain than is necessary.

Uri Dadush is the director of Carnegie’s International Economics Program. Moisés Naím is a senior associate in Carnegie’s International Economics Program. Bennett Stancil is a researcher in Carnegie’s International Economics Program.