Couldn't have said it better myself

I couldn't have said it better myself - so I didn't:

Commentary by Kevin Hassett

June 1 (Bloomberg) -- There is an old joke that a borrower dies if everyone stops believing in him. A look at the history of financial crises suggests there is a kernel of truth in this.

That’s why the California budget crisis may well lead to a second financial calamity that would be far worse than anything experienced over the past 18 months.

California is, of course, facing a debacle. Voters rejected a series of ballot initiatives designed to restore some sense of sanity to the state’s budget. As a result, California is more than $21 billion in the hole.

Governor Arnold Schwarzenegger is struggling to find enough spending reductions to close the gap, but investors are skeptical. According to Fitch Ratings, which in March downgraded California’s general obligation bond rating, California has the worst rating of any state.

Even amid economic calamity, the people of California are relatively wealthy, and the state’s economy is an impressive engine. If California were a country, it would have the eighth- largest economy on Earth. Given those advantages, the notion that California might default on its government debt might seem farfetched. After all, the reasoning goes, they can always raise taxes to pay off debt. Even a gridlocked legislature might act if California gets too close to the edge.

The problem with that line of thinking is that California’s politicians might get little notice that desperate times are at hand. For some borrowers, the first sign of problem is their inability to make an interest payment. For others -- and here lies the nightmare scenario -- the problem first becomes visible when all the lenders disappear.

Lenders’ Response

Imagine, for example, that California returns to credit markets in the coming months simply to roll over some of its expiring debt. Maybe the state borrowed money from China for two years back in 2007 and now has to borrow again to give the Chinese their money back. What happens if, seeing the catastrophic budget situation, lenders decide to shun California altogether?

If that happens, California would have to default on its obligation to give the Chinese their money back. It might do so by extending the terms of the existing debt, but that would be, nonetheless, a default, and a run on California debt surely could ensue.

Once a panic occurs, similar assets tend to be swept up in the wave. Bad news spreads. Witness the run that occurred during the Asian financial crisis of the late 1990s.

So if the unofficial eighth-largest economy fails on its debt, might the debt for the largest economy go with it?

Deficit and GDP

A look at President Barack Obama’s budget suggests that the U.S. government’s fiscal situation is in worse shape than California’s.

The deficit relative to gross domestic product for the entire U.S. this year is 12.9 percent, according to White House estimates released last month. If California had the same deficit relative to its GDP, it would be short about $230 billion -- 10 times the size of its current shortfall.

What’s worse, the Obama administration’s attitude toward economic policy comes right out of the California playbook.

Notwithstanding White House claims that the federal deficit will drop to 8.5 percent of GDP next year, there is little cause to believe that the U.S. faces a brighter future than California. That shouldn’t come as a surprise.

The Democrats have controlled the California legislature for most of the past four decades. In spite of protestations by the occasional powerless Republican governor, the Democrats adopted economic policies that define left-wing nirvana.

Top Tax Rate

Roughly 40 percent of California’s income-tax revenue comes from the much-harped-upon top 1 percent of earners. Thanks in part to the “millionaire tax” approved by voters in 2004, California’s income-tax rate has reached 10.55 percent on the highest earnings -- second only to Obama’s native Hawaii, which taxes some income at 11 percent.

High tax rates on individuals, of course, hit many small businesses hard. If you wonder why the California economy is going so much worse than most of the country, this is a good place to start.

California has to answer for its treatment of corporations as well, socking them with an income-tax rate that is just shy of 9 percent. Since the U.S. federal rate is so high relative to our trading partners, corporations that operate in California face a combined local and federal tax rate higher than that of any other country. (Japan is a distant second.)

In case you wondered, California’s sales tax is high, too. Most places in California, the combined city and state sales tax rate is more than 8 percent.

California is in crisis because state spending is so high that even those hefty taxes aren’t enough to balance the budget.

California in D.C.

Except for the sales tax, the Obama administration’s plan is to copy California’s policies.

Obama has proposed a massive tax increase on U.S. corporations by curbing the deferral of taxes on corporate income earned abroad. He also has advocated higher marginal tax rates on the rich, by letting George W. Bush’s tax cuts expire.

Even with those tax hikes, Obama projects that deficits are here to stay because, like California’s Democrats, Washington’s can’t resist increasing government spending.

It is easy to see how investors might stop believing in California. If they do, it would be rational for the U.S. to be next.

OK. Now what? California has been the Left's Little Utopia for, what was it, 4 DECADES!!?? And with the highest taxes in the F&^%^$!!!! country, California is very near a massive default!!?? Substantially ALL of California's insanity was covered up by the very credit bubble the ignorant Left claims Bush created. Let me ask you guys on the Left something: Have you EVER read the Federal Reserve Act? What makes you think ANY sitting president has control over monetary policy? Yes, Obama could refuse to reappoint Bernake... and I got a better shot of having black hair again. Obama IS going to reappoint Bernake. Does he now get the same beat down you guys laid on Bush for his economic policies (I know, Iraq... a superbly dumb idea... but we are talking economic policies here).

The truth is BOTH parties, and both extremes of political philosophy have led the U.S. to the precipice.

The U.S. appears to me to have entered an era where interest costs on the debt will grow faster than real GDP. As I see it, the Administration has 3 options (much of this influenced by the Mad Scientist) to deal with an exponentially increasing budget deficit and a massive Treasury debt funding shortfall:

1. The U.S. could default outright on its debt. Pull a Russia or Argentina. Politically, this is at once the most unthinkable, but probably the best possible thing, that the administration could do to protect the U.S. from an internal political crisis. I also give this no shot of occurring (The MS gives this a greater, albeit small, chance of occurring).

2. The U.S. could engage in a one time currency devaluation. All debts would remain constant, but each dollar or deposit or Treasury bond would increase by a factor of "X", i.e. if you had $1 million in the bank yesterday, today you now have $2 - which would mean a 50% devaluation of the currency. I give this a very low probability of occurring.

3.. Monetary (and price) inflation by means of the Federal Reserve buying the Treasury's debt from money created out of thin air. I give this the highest probability of occurring, and the most likely to be tried first (if this does not succeed then choices 1 and 2 obviously become very probable - we will have little to lose).

The U.S. bond market is already beginning to show signs of distress, with long bond prices down over 25% for the year. Higher interest rates, together with front month Oil having risen back to nearly $70 per barrel, will in the very near future be quite challenging for the U.S. economy and equity markets, and somewhere in this confluence of events we hope an opportunity is created.

The equity market appears to believe that a "V" bottom is in, primarily because the data of late is "less bad" than it had been (said data is still getting worse, but at a slower rate). The U.S. equity market lost nearly 8,000 Dow points, peak to trough, and has since gained back 2,400 or so of those... so, only 5,600 or so to go, right? While this might actually occur as a result of hyper-inflation (a case where it was necessary to cure the fever by killing the patient), I think the U.S. equity market will present better entry points before the end of the year, and will not see the "benefits" of hyper-inflation until well after the fact.

Of coursed, I could be wrong... but no where near as off as the MoRons that came out of San Francisco city hall... I want to congratulate those nitwits on the coming unimaginable unintended consequences.

Mentatt