The Free-for-all in California Jude Wanniski August 7, 2003

Memo To: Californians
From: Jude Wanniski
Re: The Source of Your Problems

I’m no longer a Californian, but I do know how seriously you take your state politics. When I was still a student at UCLA, I cast my very first vote for Edmund G. “Pat” Brown, the Democrat who won the governorship in 1958. Younger Californians may not know that Jerry Brown, who was later governor and is now Mayor of Oakland, is Pat Brown’s son. I see that in the recall vote you will have October 9 to decide whether Gray Davis will remain as governor there will be a free-for-all to replace him, if he is recalled. I’m pleased to note that Arnold Schwarzenegger, the actor, and Arianna Huffington, the conservative columnist, have made themselves available should you finally decide that Davis must go. The more the merrier, as I see almost 400 of your fellow citizens have taken out papers to get on the ballot, although they may not all file and pay the small fee by the Saturday deadline.

To tell you the truth, as a resident of New Jersey I can’t really say how I would vote on the recall. I’m just too far away to get a feel for who would be the best choice for governor going forward. I’m now a registered Republican (having switched parties in 1978) and would tilt in that direction even at a distance. This is an unusual situation, with Governor Davis having won re-election last November by a wide margin. That counts for something. And while I respect Mr. Schwarzenegger as a serious candidate, I have no idea how he would approach the office at a time when the state finances are in such terrible shape. I’ve know Arianna Huffington for years and agree with her in a great many areas, but her strengths have always been in the social issues and I have less confidence that she would be able to come to grips with the state’s economic condition.

What I do know is that most of California’s financial problems are the result of the monetary deflation the entire country has been subjected to over the last several years. That is, the boom and bust you experienced between 1997 and 2001 was the result of the Federal Reserve Board’s failure to recognize that the swings were caused by the decline in the dollar price of gold over those years. In other words, your financial crisis is ultimately the result of the August 1971 decision by President Nixon, another Californian, to “float the dollar.” A large part of the boom you experienced was the result of the fact that your service and technology sector benefited in the first stages of the deflation. That's when commodity prices went into decline as gold led the way from its elevated level of $385 in 1996 to as low as $250 in 2001. I warned the Bush Treasury early in 2001 that this would happen, just as I had warned the Clinton Treasury in 1997 of the coming collapse in commodity prices. In both cases, my warnings were ignored, which is not surprising because there were very few of us who understood the dynamics of this particular kind of deflation. Gray Davis never knew what hit him. Like most Americans, he expected the 1991 tax cuts and interest-rate cuts to pull the economy back on track.

Other states have of course experienced the same sort of deflationary problems, especially as they have affected state revenues. It is because California is so top-heavy in its production of intellectual goods that it took such a big hit when the deflation caught up with those goods relative to commodities. It was nice when the deflation gave you oil at $10 a barrel, but nobody seemed to notice that investments in the oil industry stopped cold for two or three years at that level. When the world economy rebounded and the worst of the deflation ended, the world in general and California in particular asked for more energy and there was none to be had at $10. When oil went to $35, your power bills skyrocketed and you blamed Gray Davis, when you should have blamed Alan Greenspan.

What to do now? Well, if I were governor of California, I would not raise taxes. The $38 billion deficit at the state level sounds like an enormous number, but it is really only $19 billion a year covering two years. And California’s Gross Domestic Product last time I looked was about one-sixth of the nation’s, which puts it in the trillion-dollar class. The state’s creditors would cover that amount with relatively low interest rates, especially if the state took actions that would contribute to economic expansion – with a concomitant expansion in state and local revenues. The first thing I'd do would be to eliminate entirely the state’s capital-gains tax, which should have been done long ago. Of course you would then get no revenues on that account, but considering that most of your high-tech industry has moved into the area of capital losses, that would not be much. And the rest of the economy would benefit with the greater availability of capital forming within your borders. Intellectual and financial capital now leaving the state for a more hospitable climate would also have second thoughts and stick around. State and local revenues from all other tax sources would swamp the static losses on capgains.

If I were governor of the nation’s most populous and richest state, I would take the lead in supporting federal monetary and fiscal policies that would benefit all the 50 states and the world at large. None of these problems can be solved in a satisfactory way as long as the dollar continues to float without an anchor to gold or any other commodity. Even Milton Friedman, another Californian, has recently announced that he made a mistake in pushing the quantity theory of money that led to the wild swings in the dollar’s value relative to the entire galaxy of dollar prices. There is plenty of supply-side economic talent available in California, even to Gray Davis. There is Alvin Rabushka and Robert Hall of Stanford, the bipartisan team that developed the “flat tax” concept. And of course there is always Arthur Laffer, who seems to have time on his hands to pitch in and help. How about a "Laffer Commission"?

In the end, it may be the best thing that comes out of the recall movement is to shake things up enough so that all the conventional thinking is put aside and answers are sought outside the box. As an expatriate with fond memories of my California days, I would chip in whenever asked for advice, free of charge.