For the last couple of months I have been particularly fascinated with California’s economic mess. For at least thirty years I was fascinated that Californians could not only survive but thrive despite despite extraordinary high housing costs. Every year I expected the cost for a house in California to come back to a smaller multiple of the national average. Every year I was wrong.

Despite the housing costs California and myriad of lesser problems, California remained an attractive destination for people looking at potential job moves. California is a beautiful place to live with a great climate. It did have some significant drawbacks. It had one of the highest tax rates. Based on the taxes it placed on businesses, it ranked one of the three worst states for businesses. The state government seems unable or unwilling to deal with the budget problems. Then there are the water problems, electricity problems, and the strict environmental regulations. Despite all of these problems California kept chugging along until recently. For many years people ignored these problems and looked at moving to California as a step up in life style. Recently that trend has reversed and people who have the means to move have been leaving the state.

In a remarkably short time all of the good qualities about California have been overwhelmed by the collapse of the housing market and the financial collapse of the state and local governments. Existing house prices have been in free fall for two years and the construction market for new houses has disappeared. When you combine this trend with the most severe recession in at least twenty years, it is unlikely we will see the real estate market bottom out this year. The state and local governments which had consistently grown over the years of the real estate bubble are now saddled with very high salaries and benefits. Several towns are seeking to break labor agreements via bankruptcy. A the state level the sales tax and income tax revenue are expected to come in dramatically below the budget. Despite the severity of the financial problems the state legislature has been unable to pass the spending cuts or the tax increases necessary to balance the budget. So the governor is implementing a mandatory furlough for state employees to conserve cash. Everyone knows that this is a temporary fix. The real question is what will the state do about a long term short fall in revenue. Will they try to raise taxes or will they cut state spending? Can the state legislature pass a balanced budget for the good of the state? Has the democratic process failed in California?

It is at this point I find comparing the economic messes that the US and California are facing to be enlightening. I see California as a test market for assessing possible federal policy changes. Since California has very little financing flexibility left, they will soon be forced to decide whether to raise taxes and cut government spending. It is likely to be a bitter and divisive political battle and it is likely they will do both. Raising taxes will further exacerbate the business environment in California and encourage more businesses and tax payers to move to other states. The same budget and political issues exist at the federal level. The big difference is that the Democratic party controls the decision making at the federal level. If the Democratic spending plan does not stimulate the economy, the people will blame the Democratic party and the fragile coalitions within the party will shatter as the voters seek hope and change elsewhere. My best guess is that our recession will be beginning to end when our politicians start talking about making our federal government and our budget deficit smaller. The federal government is not omnipotent. Ultimately we need a lot more tax payers who are not government employees to have a sustainable economic future. Without progress toward a more sustainable economy, we risk high unemployment and stagnant economic growth for several years. We are on the verge of repeating the mistakes of the 1930’s.