Hamish McRae: Tough test for Arnie to put California's house in order

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It is fun for California but does it matter to the rest of the world?

It is fun for California but does it matter to the rest of the world?

Well, California certainly is significant because it is the largest economy in the US. It is also a particularly successful part of the US economy. So maybe you don't need good local government to support an economic success story? On the other hand, some political developments in California, such as Proposition 13, which started the trend to lower tax rates in the 1970s, have achieved huge resonance in the rest of the world.

Some thoughts about California, and then some about the significance of its new Governor. The first thing to be clear about is California's size. It has some 36 million inhabitants, somewhat fewer than Spain but much more than Canada. Last year the economy generated a GDP of $1.392bn (£837m), just behind France - and France has 59 million people - making it the sixth-largest economy in the world. (See chart).

It has also pulled through the recession in pretty good nick. It seems to be growing 1 to 2 per cent a year faster than the US as a whole. Northern California was very hard hit by the hi-tech bubble but the state as a whole seems now to have recovered most of the lost ground. Employment is up 238,000 this year, whereas the US is down; and it is up 213,000 since the recession began - again the country is down. It manages this despite a top marginal rate of local income tax at 9.3 per cent, among the highest in the US. Add Federal taxation and top earners, in theory at least, pay more tax in California than they do here, even after Republican tax cuts.

Do these taxes drive away people? Yes, they do. More US citizens leave California for other states than arrive. However, the total population is still rising because of the flood of illegal immigrants from Mexico. In the short term this is great for the economy, for these immigrants have come to work, thus boosting the labour force. But this is a fragile relationship - to rely on illegal workers, while the existing population on balance is moving out. Besides, illegal workers don't pay income tax. So from a fiscal point of view the switch is a disaster.

The fiscal position really is alarming, though the problems are not new. In essence two things have gone wrong. One is that the state came to rely on the surge in revenues that it accrued thanks to the hi-tech boom and associated soaring property and share values. It assumed that the rise in revenues was solid and spent the money.

The other is that Californian politics have made it difficult to sustain sensible fiscal policies for a long time. Don Straszheim, an economist based in Santa Monica, points out that the state budget has not been passed on time during 15 of the past 17 years. It needs a two-thirds vote for approval and that is hard to get in a partisan world.

In addition, a large part of the state budget is outside the control of the Governor and legislature: it is fixed by referendums and democratic initiatives. So not only is the room to manoeuvre very limited; most of the decisions are in fact imposed on the politicians, thereby allowing them to shuffle off any responsibility for the consequences. The result is a gap of $40bn in the state budget, about the size of the Chancellor's budget deficit here, but on a much smaller revenue stream. In a very small way, our own Government has made the same mistake as California, assuming that revenues would grow if the economy went on growing, not realising the exceptional nature of the late 1990s boom. But the orders of magnitude are different.

So it is a mess. Does it matter? It may. The new Governor has a hostile legislature, a lot of angry Democrats in the bureaucracy, and quite possibly a number of legal challenges in the weeks ahead that may delay his taking over. In any case we don't know much about his plans, nor even why he has been elected. Is it Hollywood glamour? Or do voters actually want fiscal probity?

One worst case would be a default. The nearest parallel in the past is perhaps New York in the 1970s, when the city was on the verge of bankruptcy thanks largely to excessive spending and tax levels that drove business away. The city was rescued by a series of cuts in spending, new borrowing, and some help from the state of New York. It damaged the credit rating of other dodgy US borrowers and undermined the dollar. But it did not default and as a result its plight did not, however, undermine faith in US securities in any catastrophic way. But it could. Essentially the new Governor has to persuade voters that sound fiscal policy matters: that pain today is worth progress tomorrow. There is an assumption among politicians that voters want more spending and lower taxes, a combination that is of course impossible to deliver. At one level that is right. But people are not stupid as to realise that this is really on offer in anything but the very short term. In California the extraordinary success of the economy had enabled politicians to appear to be able to deliver better services (or at least more expensive ones) while keeping taxation at a level that did not seem to drive too much business away. But that is the past. Tough is now.

And that may be the key to Arnold Schwarzenegger's success. Voters do seem to want tough, or at least the appearance thereof. What we will all learn soon is whether they really want it.

There are therefore three levels of significance for the rest of the world. One is the potential damage to the credit rating of US states and US securities more generally. A default would have some knock-on effect of course. In an extreme case it would damage the dollar, something that would not be a great idea right now. But default is not likely unless a series of other things go wrong.

The second is how the Californian business community reacts to its new Governor. Many politicians have made their careers by being anti-business. If a pro-business politician becomes popular then the game changes - and not just in the US.

And third, we will learn whether ordinary voters want sound fiscal policy. If they don't - and frustrate any efforts to impose it on California - then this will be bad news for the taxpayers of the world in a few years' time. If they do, then the present government deficits in all the main economies of some 4 per cent of GDP may come to be seen as grossly irresponsible, which of course they are.

So see California as a test bed. It is the most innovative society on earth but it is also the place where policies are tested to destruction. It has been an extreme version of public excess. It has now taken an extreme measure to try to end that. If voters really want tough, they will get it.