Could Eurozone Debt Collapse Hit CA?

As of 2011, California received $89 billion in fund transfers from the federal government. That was on top of the state’s own $87 billion general fund budget, according to the California Legislative Analyst.

What would happen to federal fund transfers if the U.S. Federal Reserve Board went broke and the bond market collapsed due to a ripple effect of the Eurozone debt crisis?

This heretofore implausible question derives from respected financial historian Martin Hutchinson’s recent observation that the U.S. Federal Reserve is so overleveraged at a 60:1 debt ratio that a slight rise in long-term interest rates of four tenths of one percentage points — 0.4 percentage pionts — would be sufficient to wipe out its capital.

Hutchinson, a mathematician, Harvard MBA and author of the book Alchemists of Loss: How Government Intervention Crashed the Financial System, states:

“Needless to say, a rise of 4-5 percent in long-term interest rates, back to a historically normal level 2-3 percent above the true level of inflation, would put a hole in the Fed’s balance sheet that in current stringent budgetary conditions would be politically impossible for the U.S. Treasury to fill. Thus if a debt default in the Eurozone spread even partially to the over-indebted economies of Britain, Japan and the United States, not only will government bond markets be wiped out, but central banks in their current form will disappear also.”

It is a naïve notion that states send their federal tax dollars to Washington, D. C. and the feds transfer it back based on federal policies. California receives about 78 cents on each dollar it sends to Washington, DC.  But fund transfers include more than what states get back in return. Such transfers also includes what the federal government funds by printing its own money and going into debt.

Unlike state and local governments that must undertake a semblance of balancing their budgets, the federal government has no such obligation and can go into long-term debt in order to finance wars, emergencies and even entitlement programs. The federal government does this through the Federal Reserve, a private bank that is authorized to “make money” and manipulate interest rates, something states cannot do.

If the Federal Reserve and bond markets went bust, this would force the states into painful self reliance, especially if there was no concurrent deregulation.

Federal Highway Trust Fund Precarious

For example, the Federal Highway Trust Fund is already described as “precarious.”  Not only has funding been cut for 2012, but there is a conspicuous absence of funding for high-speed rail such as the California High-Speed Rail Authority, as well as of funding for light-rail projects such as the extension of the Gold Line light-rail system in the suburbs of Los Angeles County.

Highway funding has not been authorized past 2012. On Nov. 14, House Transportation and Infrastructure Committee Chairman John Mica, R-Florida, sent a letter to Senate Environmental and Public Works Chairman Barbara Boxer, D-Calif., that a proposed Senate highway bill will “essentially bankrupt the Highway Trust Fund and make it impossible to provide funding for fiscal year 2014.”

The Republican-controlled House is trying to find a new long-term revenue source for highway funding from expanded offshore gas and oil exploration.  This would be done through a proposed new transportation and energy bill called the “American Energy and Infrastructure Jobs Act.”

Boxer and others have criticized the proposed bill because there wouldn’t be enough oil and gas royalties to cover the $109 billion level needed to keep the Highway Trust Fund from going insolvent.  Neither would the funding arrive fast enough to fund the new measure or fund pet projects currently being planned or underway.

Using oil royalties to fund transportation projects would undermine the concept of a trust fund supported by highway user fees.  But user fees wouldn’t pay for many transport projects anyway, such as California’s Bullet Train, which would require continual subsidies.

The Republican attempt to shift the federal highway tax base to offshore oil royalties is obviously a way to try to get more offshore drilling permits, which the Obama Administration has been incredibly dragging its feet on in the midst of a deep economic recession.

This is no different than Democrats who, in the past, have conditioned receipt of federal highway, education and Medicare funds on California cleaning up its smoggy air basins, which resulted in the California Energy Crisis of 2001.

On October 27, 2011, House Republicans introduced a bill, H.R. 3264, that would return authority to the states to determine their own transportation projects. This would put a halt to withholding highway funding from states unless they complied with other federal mandates. No more tax-transfer extortion.

Both the U.S. House and Senate are reportedly playing a game of “kick the can” down the road, or in this case down the highway, because the government is unofficially broke.  The federal government is running a $1.299 trillion deficit for 2011-12 and is $15 trillion in debt, if the official deficit numbers of the government are reliable. As noted liberal economistLawrence Kotlikoff has stated, “The U.S. is bankrupt but we don’t even know it.”

And the Congressional Supercommittee to resolve the Federal debt has come to a predictable demise.

How Eurozone Debt Default Could Spread to CA

What is potentially threatening state and local governments now is the threat that credit default swaps — or insurance against financial loss issued by U.S. banks — will be called upon to bail out the financial collapse of the Eurozone.

European default could require Goldman Sachs to pay $2 trillion of claims, or against $2 trillion of losses, on credit default swap insurance it possibly purchased from U.S. banks that have gone under or are considered “Too Big to Fail.”

Thus, Martin Hutchinson’s scenario, whereby a debt default in the Eurozone spreads and wipes out central banks and bond markets, is plausible.

It may not necessarily be the Republicans in the House that cancel funding for the California Bullet Train.  It might be a wipeout or partial run on the U.S. central bank and the bond markets from a viral Eurozone debt crisis.  As events are unpredictable and actions are being taken to avert this possibility, there is no way to know for sure.

Keep an eye on how Goldman Sachs deals with the Eurozone crisis.  It may have ramifications for California.

(Wayne Lusvardi is a Political Commentator. This article was first posted  on CalWatchdog.)

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