A just released study calculates the total state and local government debt in California as of June 30, 2015, at over $1.3 trillion. Authored by Marc Joffe and Bill Fletcher at the California Policy Center, this updates a similar exercise from three years ago that put the June 30, 2012 total at $1.1 trillion. As a percent of GDP, California’s state and local government debt has held steady at around 54 percent.
For a more detailed analysis of how these debt estimates were calculated, read the studies, but here’s a summary of what California’s governments owe as of 6/30/2015:
(1) Bonds and loans – state, cities, counties, school districts, community colleges, special districts, agencies and other authorities – $426 billion.
(2) Unfunded pension obligations (official estimate) – $258 billion.
(3) Other unfunded post-employment benefits, primarily for retiree health insurance – $148 billion.
This total, $832 billion, ignores the fact that these pension obligations are officially calculated based on a return on investment projection that currently hovers between 7.0% and 7.5%, depending on which pension system you consider. But CalPERS, the largest of California’s roughly 90 major state and local government worker pension funds, has already determined they will have to lower their rate of return projection to 6.5%, an action that when emulated by other pension systems will immediately raise the unfunded calculation from $258 billion to $390 billion.
Our estimate, which is uses the assumptions municipal credit analysts for Moody’s now use when evaluating the credit-worthiness of cities and counties, uses a rate of return projection of 4.4%. That rate is based on the Citigroup Pension Liability Index (CPLI), which is based on high grade corporate bond yields. This rate is far more “risk free” than 6.5%, much less 7.5%, and when you apply this rate to calculate the present value of the future pension obligations facing California’s state and local governments, the unfunded liability soars to $713 billion, bringing the total of bonds, OPEB and unfunded pensions to $1.29 trillion.
This $1.29 trillion does not include deferred maintenance and upgrades to California’s infrastructure, nor does it include California’s share of federal debt. More on that later.
For the moment, let’s just assume the pension funds manage to earn around 5.5% per year. That’s less than the reduction to 6.5% they’re already acknowledging, but it’s more than the 4.5% that professional credit analysts are already using when reporting credit ratings for government agencies. That 5.5% assumption would put California’s total state and local debt right around a $1.0 trillion. How much would it cost to pay off a cool trillion in 30 years at a rate of interest of 5.5 percent?
Seventy billion dollars. That’s over $5,000 per year for every household in California. Just to make payments on debt. That’s before any payments for ongoing services.
It gets worse.
As noted in the study, if one allocates federal debt according to state GDP, the share affecting Californians adds another $1.8 trillion to their debt burden. Again, using rough numbers, we’re now talking about $15,000 per year, per household, just to make payments on local, state, and federal government debt.
Nobody knows how this will unwind. If interest rates rise, debt service will rise proportionately. To spark inflation to whittle away the impact of debt payments may be the most benign scenario, but only if inflation affects wages and not just assets. Most scenarios aren’t pretty.
The study concludes:
“Combining California’s debt with publicly held federal debt, we estimate a total debt-to-GDP ratio of 125% (or 153% using the broader definition of federal debt). This level places California distressingly close to peripheral Eurozone countries that faced financial crises in 2011 and 2012. Portugal’s 2015 debt-to-GDP ratio was 129% and Italy’s was 133%.”
While recommendations were beyond the scope of this study, here are three:
(1) Reform pensions and compensation for government workers so they experience the same financial challenges and opportunities as the citizens they serve. Cap pension benefits at twice the maximum Social Security benefit (around $62,000 per year). At a minimum, enact these reforms for all future work performed, both by new and existing public sector employees.
(2) Invest a significant percentage of California’s pension fund assets in infrastructure projects here in California. By using a lower rate-of-return projection, pension funds can compete with bond financing. They will earn a risk-free rate of return, California will rebuild its infrastructure, and millions of citizens will be put to work.
(3) Reverse the extreme environmentalist agenda that controls California’s state legislature. Enact reasonable reforms to enable development of land, water, and energy to lower the cost-of-living and encourage business growth. Private sector unions should be aggressively leading the charge on this.
There are a lot of good reasons why California is probably not destined to endure the financial paroxysms that already grip nations such as Italy and Portugal. Our innovative spirit and creative culture still attracts the finest talent from around the world. But California’s political leadership will have to admit there’s a problem, and make some hard choices. Hopefully when they finally do this, they will be thinking about the citizens they serve.