California running out of money

California lawmakers just got a Henry Paulson-like ultimatum from state officials: If they don't act, the state could be forced to suspend road, bridge, and other public-works projects as early as next week. Come March, California will be out of cash for even day-to-day operations.

A confluence of the national recession and years of legislative budget games is squeezing the Golden State as never before. Although it's not the largest budget gap the state has ever faced, this time it will be harder for California to get help from private lenders. Standard & Poor's now ranks it lower than any other state except Louisiana, which shares the same rating.

The question is: Will lawmakers finally make the tough budget decisions they've put off for so long?

"Because California does have a perennial budget crisis, it's very easy to fall into the 'boy who cried wolf' syndrome," says Dan Schnur, director of the Jesse M. Unruh Institute of Politics at the University of Southern California. "This time the sky is really falling."

The state faces a $28 billion budget shortfall over the next two years. If nothing is done, nearly $5 billion in public-works projects could be halted in little more than a week for lack of bond sales – everything from bridge replacements to a new highway tunnel and billions of dollars' worth of school construction, according to state Treasurer Bill Lockyer.

Already, the state failed to attract enough buyers three weeks ago to sell all of the bonds it had floated, he told state lawmakers Monday. "Expecting investors to purchase our bonds now, when we can't agree on a budget that lenders can rely on, is like expecting someone to buy a stock when they know it's losing value," said Mr. Lockyer.

He and three other state finance officials testified Monday in a rare joint session of the legislature.

The picture worsens next spring if legislators don't pass some plan to increase revenues or cut spending or both. California will run out of operating cash in March, state controller John Chiang told the lawmakers. The recession has severely squeezed state tax revenues.

Normally, the state would borrow to cover any shortfall. But internal revenue sources have already been depleted and outside lenders are less accommodating.

"It's not because of [California's] economy, because it's deep and diverse," says David Hitchcock, primary credit analyst for California with Standard & Poor's. "It's because, financially, they've had budgets that have not proved realistic. They've had large deficits and they've only been able to pay for their budgets through borrowing for the last couple years."

Mr. Chiang said the state may be forced to seek special loans at exorbitant rates or issue IOUs to state workers and vendors, further damaging the California economy.

"Failure is not an option here," said Chiang, referring to the need to align state spending and revenues. "It would take years to recover ... deepening and prolonging the recession."

Bringing the budget back in line will require drastic cuts, significant tax raises, or both. Those options will harm the economy in the short run and cost the state jobs – but so would any delay in taking action, said legislative analyst Mac Taylor.

Not fixing the budget would worsen the state's credit rating, making infrastructure projects even harder to fund.

"It means that the stimulus that we all want won't occur," Lockyer said. "Millions of dollars that would have gone to thousands of private-sector businesses, creating tens of thousands of jobs, will be cut off."

Other states are stuck in similar positions of budget duress, making federal money key to jump-starting their economies, says Stephen Levy, director and senior economist at the Center for the Continuing Study of the California Economy.

Washington could also help California by backstopping state and local bonds with a federal guarantee. That would reassure investors, preventing the freeze-up in infrastructure projects. It would almost certainly cost the federal government nothing, says Mr. Levy. President-elect Obama hasn't advocated this yet, he adds, but his advisers are discussing the option.

Even with federal guarantees for bonds, lawmakers in Sacramento would still have to tackle the budget deficit, notes Levy.

During the joint session, members listened attentively, but their questions and statements afterward didn't reveal much softening of positions. Republicans signaled continued opposition to tax raises, while Democrats stressed they had already countenanced "devastating spending cuts" and some new revenue was needed. Democrats are a few seats shy of a full two-thirds majority needed to pass a budget on their own.

"It's not clear what my colleagues on the other side of the aisle want," said Karen Bass (D), speaker of the state Assembly, who helped organize Monday's joint session.

"I didn't hear anything that was new today," says Sen. Jeff Denham (R). "People around the state would expect us to deal with all of the waste first, get rid of all the bells and whistles."

To that end, he's proposing eliminating a $2 million waste-management board and supports selling state property, like San Quentin prison. He would close tax loopholes but wouldn't name any taxes he thought Republicans would be willing to raise.

"My guess is you can find a small number of Republican votes for additional taxes if there is a trade-off for some job and business incentives," says Mr. Schnur. Possible incentives include scrapping stringent 40-hour workweek regulations and scaling back on the state's ambitious greenhouse-gas targets, he says.