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September 25, 2003

Lessons From California’s Budget


Correction Appended

CALIFORNIA'S off-again-on-again election is moving toward a climax, and it's a cliffhanger. Gov. Gray Davis is fighting for his political life.

It looks as if Arnold Schwarzenegger has the Hummer owners' vote sewed up, but even in California that's not enough to win an election. The far right sees Mr. Schwarzenegger as too liberal for their tastes, so there's a chance the vote will split, leaving Governor Davis, or at least the Democrats, with a victory.

But even if Mr. Davis retains the governorship, his political future looks bleak. How did he get into this mess?

The governor was hit with two big economic crises: the blackouts in the spring of 2001 and the budget shortfall of 2002-3.

These two episodes offer some useful lessons in economics. Understanding what went wrong may help avoid such disasters in the future.

Governor Davis certainly can't be blamed for the electricity crisis: the fatally flawed electricity deregulation policy was created in the previous administration.

They say a camel is a horse designed by committee, but this plan was more of a wart hog. It required all electricity purchases to be made in a spot market, virtually eliminating long-term contracting, and was vague about who would pay for more transmission facilities.

As a result, investment in generating capacity was delayed for several years while the industry haggled over who would pay for needed improvements. During this period the demand for power continued to grow.

When a few generators went offline for maintenance in the spring of 2001, it became apparent just how vulnerable California's power supply was. The shortfall in supply, coupled with fixed retail prices and the inability to make long-term contracts, ceded market power to sellers of electricity.

" Enron-style market manipulation was part of the problem," said Severin Borenstein, director of the University of California Energy Institute, "but the real root cause was shortages, some real and some created by sellers who had an incentive to drive up prices."

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.

Getting no help from Washington, the governor was forced to sign disadvantageous long-term contracts, obligating electricity distributors and consumers to pay high prices for electricity for years to come.

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.

So if the electricity crisis didn't cause the deficit, what did?

Fundamentally, the deficit is a hangover from the days of irrational exuberance. 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.

When money flows in, governments find it hard not to spend it. This is particularly true in California, thanks to mandated spending constraints. For example, Proposition 98, passed in 1988, requires the state to spend 40 percent of general funds on education from kindergarten through high school. As a result, spending, both automatic and discretionary, rose in parallel with tax revenue.

Then the house of cards came tumbling down. Revenue from options and capital gains fell to $8.6 billion in 2001-2, and $5.2 billion in 2002-3.

Reversing those spending decisions was not as easy as putting them in place: much of the increased revenue went for education, tax cuts and other long-term commitments.

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

State tax revenues in California come basically from three sources: the sales tax, the property tax and the personal income tax. Stephen Levy of the Institute of Regional and Urban Studies in Palo Alto has looked at the historical volatility of these series. (His summary is available at

Surprisingly, he found that the sales tax base had the most volatility, in part because the sales tax excludes the rapidly growing services sector. Personal income, excluding capital gains, has grown relatively smoothly by comparison.

Mr. Levy argues that revenues from volatile sources, like capital gains, should have special treatment in budgeting: one-time revenue increases should be tied to one-time expenditures or automatically put into a rainy day fund. This is an eminently sensible suggestion.

Whoever ends up in the governor's office will face the same budget mess. Expenditures will have to be cut and taxes will have to be raised. But more important, some changes in spending policies of the sort Mr. Levy suggests should be put in place to prevent future budget crises.

Long-term reforms require a long-term vision. The last thing Sacramento needs now is a governor who is obsessed with the next election.

Correction: Sept. 27, 2003, Saturday

The Economic Scene column in Business Day on Thursday about California's budget crisis misstated the year in which some power generators shut down for maintenance, demonstrating the vulnerability of the state's power supply. It was the spring of 2000, not 2001. The column also referred incorrectly to decisions by the Federal Energy Regulatory Commission. The agency indeed imposed some price caps in California, in December 2000 and June 2001.

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