Arnold Kling  

California Reality

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Comment of the Week, 2003-09-2... Stock Options...

As a dean at Berkeley, Hal Varian has a personal interest in California. In his column today, he offers some plain-spoken economics lessons.


Most California voters think the electricity crisis contributed to the state budget deficit. If only things were that simple. In reality, not a cent of the deficit was caused by electricity prices: the cost of the crisis will show up solely in future electricity bills.

The basic economic lesson is this: a deregulated wholesale market and a regulated retail market is a recipe for disaster. If you tell a supplier, "I'll buy the same amount no matter what you charge," don't be surprised if you are charged a high price.

...California was the epicenter of the dot-com boom of the late 1990's, and tax receipts flowed to Sacramento. Tax revenue from stock-option grants and capital gains alone rose from $7.5 billion in 1998-9 to $12.7 billion in 1999-2000 to $17.6 billion in 2000-1.

...This brings us to the second lesson in economics: don't spend transitory income on permanent commitments.


For Discussion. Varian argues that it is important for states to understand the cyclical component of revenues and to make spending commitments based only on the stable portion of their tax base. What institutional mechanisms might be put in place to ensure this?



COMMENTS (14 to date)
Eric Krieg writes:

Institutional commitments? Forget that. How about curtailing reliance on income and sales taxes, which are too volatile for funding most state services.

Property taxes are not a bad way to fund organizations that, by law, must operate with balanced books every year. Say what you want about the fairness of property taxes, they are a VERY stable source of revenue.

Patrick R. Sullivan writes:

Excellent lesson in Public Choice:

" Governor Davis was, at least initially, not willing to play the one valuable card he had: allowing retail electricity prices to rise.

" When he finally did allow price increases in the spring of 2001, the resulting incentives for conservation, falling natural gas prices, and the long-term contracts he negotiated stabilized the situation. Californians turned off their electric hot tubs and adjusted their air-conditioners, and the crisis evaporated.

" Why was Mr. Davis so reluctant to allow prices to rise? He recognized that such a move would be deeply unpopular and could cost him the election the following year. He was betting that the Federal Energy Regulatory Commission would come to his rescue with price caps, or that electricity prices would stabilize on their own. Unfortunately, neither of these things happened."

Iow, democracy is a lousy way to make decisions, markets are better, much better. So, if markets can function (and they can outside of classic public goods)leave those decisions outside politics.

David Thomson writes:

“Most California voters think the electricity crisis contributed to the state budget deficit. If only things were that simple. In reality, not a cent of the deficit was caused by electricity prices: the cost of the crisis will show up solely in future electricity bills.”

In other words, most Californians are grossly ignorant and immature. Isn’t this the same silliness we find in the Old European countries?

Do I perhaps sound over the top and indulging in exaggerated rhetoric? Oh well, all I can say is that socialist nostrums eventually seem to warp the ability of citizens to think and follow a logical argument. Californians are often accused of being weirdos---and recently they have lived up to this billing!

Bruce Cleaver writes:

Isn't part of the problem recognizing that you have, indeed, *transitory* income vice permanent income? It's akin to recognizing that you are in a bubble...which California was. But that wasn't apparent to everyone, least of all politicians who by nature would want to be optimistic about tax revenues

David Thomson writes:

"But that wasn't apparent to everyone, least of all politicians who by nature would want to be optimistic about tax revenues."

I don't think this argument can hold any water. California's politicians and citizens simply refused to think like logical human beings. They instead acted like drunken sailors who just received their paycheck. The recent tech bubble has little to do with it. We are talking about immature people who prefer to live in La-la Land.

Randall Parker writes:

David, Speaking as a California citizen I could take offense at you but I figure that since you are obviously an idiot with a grudge of some sort why bother?

Some of us thought the original misregulation was misnamed "deregulation" by the lefties in the press who don't understand that retail price controls and other nonsense like the weird wholesale market they constructed are not consistent with deregulation. But since Republicans are in the minority here and Hispanic immigration looks set to ensure that is a permanent affair our only choice is to move. That is a shame because we have great weather.

As for Davis's lack of culpability for the electric power crisis: that's a laugh. He could have ended it at any time by introducing some sort of real retail price market that responded, however imperfectly, to changes in the wholesale price market. Not holding Davis responsible makes no sense since he had decisions he failed to make that would have made the situation better. Also, I think he's a liar because he obviously covered up (with help from assorted legislators) the size of the deficit in order to win reelection. Plus, there's the way he took money from the prison union and gave them a huge raise in return. I think he's just total slime.

As for the populace as a whole on Davis's decisions: heck, the guy is about to be recalled. Surely the populace, in spite of the fact that the majority voting for him twice in the first place, is capable of seeing that he ought to go (or at least I hope so).

As for the populace as a whole being responsible: Elections can be won with just 51% of the vote. This is a real problem for the other 49%. But how about holding responsible the national level politicians who are pursuing an immigration policy that is pushing California leftward into economic mismanagement and ever growing government? California used to be better governed.

As for a constitutional mechanism to keep state budgets on a more even keel (which is the reason I clicked into the comments to see what would be said about that): how about an amendment that limited the government's percentage of state GDP to some max amount? Rather than make it a single fixed max amount how about making a scaled super-majority requirement in the state legislature to go to increasing percentages above the initial max? So to, say, spend 5% of state GDP would require a 50% majority vote but to go to 6% would require 60Z% vote or something similar.

Also, there could be a formula that says that the state goverment must average a held surplus of cash reserves (held in US government or commercial bonds) that is some percentage of the GDP. Require that a 5 year running average be, say, 2% of state GDP. But the problem would be to get the government to build up a larger surplus in the good years to counterbalance what happens in the bad years. So the difficulty is how to determine what a good year is that should be a year in which the state government should increase its reserves?

One idea might be to require some percentage of increase in total collected to be set aside. If the state collected $40 bil one year and $50 bil the next then half of the increase could be constitutionally made to be unavailable for spending. But coming back from a severe recession that might not make sense to do.

We need a "fat year" detection formula. Maybe it could be based on per capita GDP changes over a 5 year running average?

David Thomson writes:

“David, Speaking as a California citizen I could take offense at you but I figure that since you are obviously an idiot with a grudge of some sort why bother?”

I should have more cautiously taken to task only the majority of Californians who decide the elections. There is no doubt that a minority of you are rational human beings. Still, in many ways your irate post supports my main thesis.
You even concede that because the crazies run the show “our only choice is to move.” In other words---you are soon to be an ex-California citizen. I think the prosecution can rest its case. Oh by the way, you might want to move to Texas. We even have our own electric power grid.

Randall Parker writes:

David, Humans have an economic incentive to concentrate more on learning about things and working on things that will help them in their personal lives instead of becoming well inforned about who they vote for. I see foolish electoral choices as something that no state has a monopoly on (I could cite examples from your own state but why bother?). Plus, plenty of voters are basically willing to vote the Robin Hood ticket because they want stuff. Democracy is never going to work incredibly well and it could even get a lot worse in the future.

Meanwhile, what do you say to Arnold's question? Is there some sort of state constitutional amendment that would cause state legislatures to to make wiser decisions on taxing and spending issues?

Frank Young writes:

Randall has some good ideas. We need more discussion on the notion that any surplus, in any year, good or bad, represents a drain on the economy. While a small percentage represents a good way to ease the burden when the economy turns south, there is a general perception that a surplus of 2% of GDP is better than a deficit of 2% of GDP.

The deficit situation represents a healthy tension requiring government to sharpen their pencils. The surplus is nothing more than a politician's vote buying fund. Then again, buying votes can occur no matter how deep a hole we're in. Never mind.

David Thomson writes:

“Meanwhile, what do you say to Arnold's question? Is there some sort of state constitutional amendment that would cause state legislatures to to make wiser decisions on taxing and spending issues?”

“Then again, buying votes can occur no matter how deep a hole we're in. Never mind.”

A constitutional amendment to curtail spending is a good idea. But this is not a perfect solution because politicians will always find excuses to bribe the voters. My point concerning California and New York is that the majority of the voters are crazier than jay birds. Instapundit, by the way, just posted this article by Paul Johnson about how insane things are in Europe:

“One thing history teaches, over and over again, is that there are no shortcuts. Human societies advance the hard way; there is no alternative. Communism promised Utopia on Earth. After three-quarters of a century of unparalleled sufferings, the Soviet Union collapsed in privation and misery, leaving massive Russia with an economy no bigger than tiny Holland's. We are now watching the spectacle of another experiment in hedonism, the European Union, as it learns the grim facts of life. “

http://www.forbes.com/columnists/free_forbes/2003/1006/037.html

I am very concerned that Californians and New Yorkers might have gone pass the point of no return. Are they as goofy as the Old Europeans? Is there any hope for them?

I should also add something else. The intellectual disease of socialism also impacts upon our physical safety. Please note how pervasive is the virus of pacifism. Voters who like something for nothing are easily seduced into thinking that military might not be required to protect the citizens. They constantly find silly reasons not to confront our enemies.

Eric Krieg writes:

>>I am very concerned that Californians and New Yorkers might have gone pass the point of no return.

This former New Yorker is here to say that they ARE past the point of no return. That is why New York has had such negative population growth. California would too if it weren't being inundated by Mexicans (evidently ANYTHING is better than Mexico).

BTW, every state is required by their constitutions to run balanced budgets. What other ammendment could you offer that restrains spending?

Boonton writes:

"I don't think this argument can hold any water. California's politicians and citizens simply refused to think like logical human beings. "

And how many hundreds of millions of dollars did the market toss into ventures like Webvan again?

"Also, there could be a formula that says that the state goverment must average a held surplus of cash reserves (held in US government or commercial bonds) that is some percentage of the GDP. Require that a 5 year running average be, say, 2% of state GDP"

There is such a mechanism, its called the bond market. States whose budgets play close to the edge will suffer higher borrowing costs than more responsible ones.

"BTW, every state is required by their constitutions to run balanced budgets. What other ammendment could you offer that restrains spending?"

Such requirements mean very little. What happens is that borrowing takes place off of the 'operating budget' which is balanced and on the 'capital budget'. It is reasonable to have borrowing for some things such as roads that may last decades or new school buildings which will provide service to the gov't for years to come.

Two market mechanisms keep spending in check. The first is the bond market which will not loan money to a state if it looks like its budget is going crazy. The second is the political market which will resist tax increases with more and more energy the higher they get.

Tom writes:

My suggestion is a [linked] two-parter:

1) State may deficit spend.

2) State may only raise the annual *nominal* spending in a year by 1/3 the size of the surplus on hand. If the state has no cash surplus, it may not raise total nominal spending.

David Thomson writes:

NOTE: Not the David Thomson commenting above - he's my evil twin and I feel obliged to comment whenever I run into him in cyberspace.

I would just like to point out that Hal Varian's comments are extremely sane; I wonder why no one could get Pete Wilson's staff to see this when they wrote deregulation (that's a republican govenor, "evil DT"). For some insight into the push for energy deregulation and a few good reasons why it is so poorly executed try Greg Palast's writings (www.gregpalast.com). Obviously economics had little to do with it.

And by the way "evil DT" ( maybe I should just call you Texan DT, you can call me Canadian DT - living in Cali), where do you get off attacking Paul Krugman? Very silly thing to do. Reminds me of the current Administration's response to the 10 Nobel Laurate economists (and 400 other economists) who signed a petition stating what a disaster their proposals were. Yes, the DOW is up, but everyone who isn't on the "team" knows its a bubble.

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