California's Gift of Shame

How IOUs, layoffs, late payments, and other bad news may still save the Golden State

How would you like to be running the California Travel and Tourism Commission right now?

The state is generating an almost constant stream of alarming news. "Essential" services from libraries to police hours to public school teaching staffs are being drastically cut. Cities are going bankrupt. This year's state budget—which currently boasts a $19 billion shortfall—has been delayed for nearly two months, with no agreement in sight between Gov. Arnold Schwarzenegger and Democratic lawmakers. Employees are being furloughed. The state will soon have to start issuing IOUs to cover its obligations. Sacramento announced Monday it would be unable to pay nearly $3 billion in school and county subsidies. Books with titles like Plunder and California Crackup detail how massive financial obligations have rendered the state essentially ungovernable.

In short, California can't buy decent press these days. (And even if it could it wouldn't have any money to do so.)

So why is this good news?

Because in a state that has seen three years of nearly solid financial pain, what is going on right now is pain with a purpose. Outgoing Gov. Schwarzenegger is using fiscal emergency as leverage toward a permanent solution to the public employee pension crisis that has gutted California's budget and hamstrung other states. If he succeeds, the example could point to a solution for the many states that need to get a handle on their public employee commitments.

First, about those IOUs. During a lengthy budget standoff in 2009, the state issued $2.6 billion in IOUs to cover payments to contractors, local governments, and residents in line for tax refunds and college scholarships. This year the budget (which is supposed to have been completed in June) is overdue again, and the differences between Schwarzenegger and the Democrats are even sharper. Last week, Controller John Chiang announced that IOUs would begin coming in late August or early September.

On its face, Chiang's announcement is an attempt to put pressure on the governor. The two are locked in a long-running legal dispute over another budget-standoff tactic: the governor's annual attempts to reduce state workers' pay to Federal minimum wage until the budget is approved—which the union-friendly Chiang claims is impossible due to the state's antiquated COBOL-based payroll system.

But on the IOU issue, Chiang has been fairly consistent in his comments, and the state will in fact need to put off payments (as it did Monday by deferring subsidies to counties and schools) very soon. In any event, the controller's comments probably ended up strengthening the governor's position, which has been refreshingly clear: Schwarzenegger is willing to risk any number of fiscal "black eyes," to court credit downgrades and bad public relations, even to leave office without a budget passed, in order to get concessions from Democrats and their union supporters.

Among these concessions: a 5 percent increase in employee pre-tax contributions toward retirement funds; changes in pension calculations to prevent pension "spiking"; and more honest disclosure of how pensions are funded. Another item that has long been on the governor's wish list is a state "rainy day fund" of $20 billion—close to what Schwarzenegger believes the state would have saved in the absence of runaway public-sector pension payouts during the last decade.

Which brings us to the most important concession of all. Schwarzenegger is seeking to undo Senate Bill 400, a 1999 law that vastly expanded pension payouts to government workers. Passed after a mere five minutes of debate, based on some highly misleading documentation and unrealistic expectations from the California Public Employees Retirement System (CalPERS), SB 400 paved the way for a nearly 3,000 percent increase in pension liabilities for the state. 

That debt is eating into other state funding. Since SB 400's passage, expenditures on environmental protection and parks have actually decreased relative to inflation. It's important to remember that Schwarzenegger's struggle is not motivated by small government principle. His problem is that commitments to government workers are preventing the state from spending on other stuff.

But he has been remarkably consistent on this, and may deserve more credit than he has received for raising the national alarm about public sector union power and the crushing burden of paying for government workers' plush retirements.

Viewed through this lens, Schwarzenegger's gambits in the budget battle—alternately described as nonsensical, petulant, and a "gubernatorial ransom note"—begin to make sense.

As of now, state employees are due for furloughs three days a month, which will amount to an average 14 percent pay cut. Critics and the media have questioned whether furloughs save the state's budget as much as advertised, but the savings are a side benefit. The real aim is to put pressure on the Service Employees International Union (SEIU) and its clients in the state legislature. Union members see actual pay reductions, and eventually, so the thinking goes, they will demand their leaders work with the governor to do something about it. (That Schwarzenegger has negotiated new contracts—which roll back most of SB400—with six unions suggests the tactic works, though the largest union contract negotiations, including SEIU's, are still unfinished.)

An even clearer use of pressure on government workers has been in the governor's (so far unsuccessful) attempts to reduce state employee pay to minimum wage for the duration of the budget delay. While Chiang and previous controllers have used the old-software excuse to avoid implementing this plan, the message still comes through: State workers are not innocent bystanders in the budget impasse. Their excessive compensation is the reason California can no longer manage its budgets.

Schwarzenegger has proven to be a master at stratagems like these, declaring states of fiscal emergency, using apocalyptic rhetoric in places, and courting the credit downgrades that would accompany another IOU experience. (Standard & Poor's already gives the state its fourth-lowest investment-grade rating of A-, and has said it may lower the score if a budget isn't signed by autumn.) Schwarzenegger's genius has been to realize that what looks like catastrophe from the outside can be pretty useful in negotiation.

Whether it helps the state's never small self-image is another matter. But Kathryn Burnside, spokeswoman for the industry-funded California Travel and Tourism Commission, says the trade group has not seen bad news keeping people away from California (though the global recession has cut into tourism). "Certainly, there has been coverage of the state's financial state, and we've seen it in international headlines as well," Burnside says. "But when people come to California, they're coming for the beaches, they're coming for the mountains, for the attractions and the resorts and the sunshine. We're not worried that political news is deterring people from coming to enjoy all the things California has to offer."

Tim Cavanaugh is a senior editor at Reason magazine.