The End of the University of ... [insert your state]

The Washington Post reported [here, Dec 14th] on the budgetary crunch at Berkeley, amidst a claimed more general trend towards less state support for higher education. As an economist, I wonder why this trimming of support took so long – not because it's laudable, but rather because it is what basic economics permits. After all, why should my state spend money to educate someone who with high likelihood will work in someone else's state? If we close down all of our state schools, businesses may have a harder time recruiting managers, but given current unemployment levels…we here in Virginia can be free riders. But the logic is the same for each and every other state: all will cut. And if the Post is on target with its story, they are doing so.^[1]

Can we find other evidence of this sort of behavior? Yes.

The generally abysmal quality of education in the old cotton-and-tobacco South reflects this logic. Plantation crops in the old days relied on brute labor, not brains; why pay for fieldhands to learn to read? That would increase their mobility, threatening the ability to get the crop harvested rather than making the local economy more productive. Equally important, a body is able to work by high school, if not by age 12 or 13. You want to spend money to keep them out of the fields?? That was true for coal mining and textile towns, too. Even in the north, my grandfather had to leave the farm to board in the city so that he could attend high school. Why, today, should residents of Florida retirement communities tax themselves to pay for the education of someone else's grandchildren? My sense is that, increasingly, they don't.

At the global level, society benefits from the constant stream of innovation that has lifted incomes for the past two centuries in industry after industry. Furthermore, by the late 1800s "basic" research underlay invention. But basic science in itself is unproductive. Few research projects pan out; those that do may have no obvious application. Even if they do, there's a (large) gap between laboratory bench and commercial product.^[2] So why bother with basic science? The answer is that most of the world doesn't. Would Mongolia benefit from spending 2% of GDP on R&D? Instead, just buy the finished products, or use hints and the poaching of the odd employee. Of course basic research provides a great training ground for high potential grad students. But such workers are internationally mobile. Why should we pay?

To use jargon, education creates a positive externality: the benefits to society increase by more than the output of the (marginal) individual. We're much more productive when we can assume that employees, suppliers and customers are literate and numerate and (nowadays) know how to use computers.

The incremental benefits to education diminish with more years of schooling. Part of the reason is that job skills aren't generic, and so it's not realistic to think that college will provide them: you can add more knowledge, and an improved ability to learn and to communicate. Valuable, but only incrementally so. Now occasionally community colleges will pair with local employers for discrete programs, particularly when there are several companies with similar needs. That helps offset one of the defects of on-the-job training, that employees will take their skills to firms that pay a bit more, enabled because they train a bit less. In general, though, college cannot, and does not try to give, "day one" job capabilities.

That doesn't mean a college education does nothing. It also socializes students (generally for the better, unlike high school) and generates a pedigree that reflects some combination of acumen, ambition, persistence and willingness to do grunt work. Employers generally value all four. So even if a diploma provides little insight into the mix, employers are nevertheless willing to pay something for a diploma. However, now that everyone who is anyone has a diploma, that alone doesn't distinguish a graduate: you need higher higher education, a masters...

So why should we fund universities when their graduates have a hard time finding jobs, when many of the courses are esoteric and unworldly – as though the Greek and Latin education of the 19th century elite wasn't! Maybe we are educating too many for too long. But cutting back on funding won't somehow lead to more "practical" training – the sheer diversity of needs in today's economy precludes that – or to would-be employers not asking to see that diploma. Instead turning our public schools private will squeeze out those youth whose parents don't have the wherewithal to pay tuition,^[3] or the sophistication to push them while young to win the scholarship marathon.

Mike Smitka

Notes:
[1] California is remote from the East Coast, at least as reflected in the job hunting practices of my seniors. Now Washington and Lee is far from average, so I don't want to read too much into that – indeed, my suspicion is that Hollywood and Silicon Valley pull workers from throughout the US, if not from throughout the world. But to the extent it's true for the state as a whole, then Californians should be less willing to see the UCal and CalState systems pared than the rest of the country.

[2] Complete Digression: Xerox

The photoelectric electric effect relied upon lab results, and the lunchtime jottings of an employee of the Swiss patent office in 1905. The cost: a pencil and some paper. While it led to a Nobel prize for Einstein in 1921, there were no practical applications. Turning it into an invention relied up the efforts of Chester Carlson, working in the family kitchen in Queens during 1936-39, to succeed in developing a "proof of concept" using light to turn words into static charges on a selenium plate in 1939, to which sulfur dust could be made to adhere. Now this work involved a bigger budget than did Einstein's, but it was within the realm of his modest Depression-ear salary. Further development at the Battelle Institute ate through rather more, at least $200,000, a tidy sum in those days. In the process they developed a better plate, an effective toner and other core pieces of a working machine. However, the first commercial product didn't arrive until the Haloid Corporation took over development work, and invested much more money. The first shipment of the Xerox Model A Copier came in 1949; the first really successful version took until 1959, after significant additional investment. Now some of this required individuals with a knowledge of physics, and chemistry, and mechanical engineering, drawing in fact from many fields. But it drew upon the stock of knowledge, and lots of good engineering. For this I draw upon Hillkirk, John and Jacobson, Gary (1986). Xerox: American Samurai. New York: MacMillan. But I double-checked this` out of curiosity against Wikipedia.

[3] Some might object that the market will handle everything: academically able students can borrow and succeed even without financially able parents. But in today's environment of dim job prospects, don't the risks to both the bank and the would-be student mean that the only sensible strategy is "to neither a lender nor a borrower be?"

First Greece, then California?

We know that Greece is in trouble. But what of California? It too is a sovereign entity within a monetary union. Chapter 9 bankruptcy, the provision that covers local governmental entities, is not available for state governments; under the US Constitution they fall outside the jurisdiction of such Federal legislation. And it's large -- 12% of the US economy, much larger than Greece is within the EU. So it may be Too Big To Fail -- perhaps we need to create the term "SIPEs" for "Systemically Important Political Entities" (cf. SIFI).

We would first need basic data. I've outlined what I know and what I think we need to know below. This is a work in progress, so will read choppily until such time as I rewrite in one sitting from beginning to end. Oh, and conclusions are at the very bottom.

1. What is the total volume of California bonds "at risk"? State finances are potentially complex -- there can be taxes that are legally earmarked for the repayment of specific bonds, e.g. highway bonds matched against gasoline taxes all covering highway maintenance separate from the general budget. So the first approximation would be General Obligation Bonds (or their equivalent), that are backed only by the full faith and credit of the state government.

• A quick google search suggests that about $80 billion are outstanding. (See "Seeking Alpha" from January 2010; the California State Treasurer gives the December 2011 General Obligation Bond total as $72 billion.) If so, then the amounts are really pretty small: with the GDP of California at about $1.8 trillion, it comes to 4% of state GDP, while Greece's (gross) debt is 116% of GDP.
• In addition the state has contingent liabilities. The big item is likely unfunded pension obligations, rumored at about $500 billion. If we use $600 billion as a total, then debt is 1/3rd of GDP. But it's not clear that the bond market factors that in, since the need to lay out cash is down the road and the amount fluctuates with the stock market.
• On 30 November 30 year Treasuries had a yield while California bonds of roughly the same maturity traded at 4.5% according to MunicipalBonds.com, or nearly a 2% premium despite their more favorable tax status -- indeed, for someone in the top income tax bracket, that would be the same as 7.6% on a US Treasury bond, a very stiff premium.

2. Who holds these bonds? Are they held by individuals who for various reasons might have a hard time "dumping" them? For example CALPERS, the state pension fund and the world's largest institutional investor, may hold so many bonds that it is unrealistic to think that they would "dump" them and be forced to book a loss. Or bond holders might be widely dispersed and typically hold only a few. In the former case, this would mute any crisis.

• My hunch is that debt however is in fact widely held, albeit almost entirely within the state of California because state debt is tax exempt and marketed within states, for example there are mutual funds restricted to California bonds. Furthermore, it is likely held by a combination of individuals and pension funds, not banks (licensed or shadow) and so would not have some of the spillover observed with sovereign debt in the EU.

3. What is the maturity of the debt? In general, the government will refinance debt by rolling it over when it comes due. So a crisis could be accentuated if there is a current deficit that would have been debt financed, and maturing debt that would have been rolled over. More generally, a non-crisis gradual increase in borrowing costs to match perceived risk only affects new debt; the longer the average maturity, the longer it takes for an increase in interest rates to increase the average interest rate on state debt and hence the share of tax revenues needed just to pay interest.

• I have no information though the unfunded pension liabilities are long-term so my hunch is that only $20 billion is short-term -- a drop in the bucket in US financial markets, even in their current stressed state (or should that be "states currently stressed"?). But that's not so small relative to general revenues in California, which I think are on the order of $75 billion.
• Floating rate debt accentuates the impact any any short-run issues. Ditto bank loans. In January 2010 (Seeking Alpha) there was $5.5 billion in floating rate notes and $6 billion in bank loans. So at that point it was over 10% of all general state debt. 

4. What of other debt? -- there is likely seasonality in tax receipts and (perhaps less so) in expenditures. How is that financed? -- bank loans? The private sector analog is "working capital".

• See above -- old data. So I don't know.

5. To what extent is California an "open" economy? -- the greater the share of trade, the smaller an impact a decline in expenditures would have.

• I'm sure California is more "open" than Greece, in that it has never been an independent nation. However it is large and physically remote from the rest of the US economy so the short-run multiplier might be pretty big.
• Greece is small, with a population of 11 million, while California has 37 million.

6. How large is the government? Again, parts of the government may be funded by taxes that can't be tapped to cover general budget items -- a debt crisis might not affect those areas at all.
CA state-level GDP is about $1.8 trillion, state and local government is about $0.2 trillion or about 11% of the economy. However there is no breakdown for the state government vs local governments. Furthermore it is not clear whether transfer payments are included (normally they would not be) and how these are handled within the state fiscal system.

• My recollection from a year or so ago is that current expenditures at the state level are about $100 billion, but that the budget was not unified and reporters in Sacramento felt that no one really had a comprehensive grasp, certainly not those in the state legislature. But this means that the state government only accounts for 5% or so of the economy.
• In contrast, for Greece we are talking about the central government, which has total expenditures of 47% of the economy and an overall budget shortfall of roughly 8% of GDP. That is very different in scale from a state government in the US, even if we lump city and country governments and the many semi-independent school, water, sewage, transit, port and other units in with the state.

7. How interrelated is government? To what extent would a debt crisis at the state level impede the operations of local government, which probably employs far more people? Most state governments transfer significant amounts of funds to local governments, particularly in support of public education. Is that the case for California?

• My guess is that the state directly employs relatively few people, indirectly many. In normal times local school systems might have the ability to tide over a temporary shortfall in funds. I very much doubt that's true now.
• However, under the California constitution education has seniority over debt service; it may be therefore that if crunch turns into default, in the first instance bondholders would be left holding the bag, not state employees. In the second instance, I suspect that the axe would fall on a great many, and that education would be affected through indirect channels.

8. Would Federal-level "automatic stabilizers" mute the impact?

• My hunch is that state employees fall outside the unemployment insurance and pension guarantee systems. Furthermore, unless I'm mistaken unemployment insurance, medicaid and various other social safety nets are actually administered by, and operate in part with funds from, the state level. So they could suffer from spillover effects that would magnify the more narrow state government component.

9. What of contagion?

• I think it quite realistic to think that local governments would have a hard time issuing bonds, even if they themselves are fiscally sound. After all, potential purchasers can always purchase Treasuries if they want long-term bonds, though for tax reasons they are imperfect substitutes. (Interest income on state obligations is not subject to either state or Federal income taxes, whereas Federal bonds typically are exempt from state taxes but not Federal taxes.)

10. What of contagion?

• If California runs into trouble, then surely Illinois also would. And local governments therein (Chicago?). Sipes! (Structurally important political entities!)

11. How big an adjustment?

• At least one mitigating factor is that the numbers I know are smallish. A current budget shortfall of $25 billion is 1.4% of California's GDP. Add in pension shortfalls of $500 billion and (spread over several years) we get a rather bigger number, but one that is still far below the 8% structural deficit in Greece. Of course this is in the context of a continuing recession and a continuing drop in real estate prices and high level of foreclosures that may mean revenues will continue to fall rather than stabilize.

• Furthermore, the political system is byzantine, not Greek. Because of the referenda system, the legislature has limited powers; it could take a long while to change the state constitution, even if the will is there, because of the mechanics involved.

12. Should we worry?

• I can't answer that question. But I don't think it can be brushed aside -- though Dani Rodrik concludes that in a November 2011 blog post. Part of the answer would be whether there is any trigger. What is clear is that the underlying structure is not fiscally sustainable. Will it however generate a "crisis"? Or a slow increase in interest rates on state debt and other pressures that will lead to a non-traumatic resolution? I certainly hope the latter, but wonder whether that is politically realistic. After all, the potential for Europe's current problems was fairly clear before the Euro was launched -- Martin Wolf of the Financial Times wrote about it in the early 1990s.
• Nevertheless, the numbers above seem pretty small, under $100 billion, not factoring in cities, counties, school districts and other bond issuers within the state that may well be tarred and feathered by what goes on in Sacramento. If a crisis developed, but were limited to California -- a big if -- then it would not be big enough to affect the US as a whole.
• In the late 1970s, before heading off to graduate school, I worked on Wall Street on Eurodollar syndicate loans to Latin America, and served as a representative of Japanese banks to the IMF organized restructuring of Jamaica's debt in 1980. (I didn't stick around to be part of the team for Brazil and other borrowers.) That was horrific in its impact on the average Jamaican, and the economy has never fully recovered. But a default by a US state would be quite different; once Jamaica began running out of US dollars, importing food and oil became problematic, as no foreign party would accept Jamaican currency. That issue would not be relevant for a subnational entity (and is not relevant in the EU -- incomes in Greece may have fallen, but if someone has a job, the euros they earn have held their value). It's important to keep that limit on the downside in mind, for Greece and for California.