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California's sorry state a major threat to U.S. Add to ...

California is to the United States what Greece is to Europe - and not just because of its abundance of sun and sea.

Busted budgets and dysfunctional politics have also made them kindred spirits.

And just as Europe is reluctantly looking at coming to Greece's financial rescue, the day may soon come when California's financial woes become a problem for all Americans.

In some ways, California may prove to be the bigger headache. Were it a country, the state's economy would rank eighth in the world - roughly the size of France and much larger than any of the so-called PIIGS of Europe: Portugal (No. 50), Ireland (No. 56), Italy (No. 11), Greece (No. 34) and Spain (No. 13).

California also makes up a larger relative share of the U.S. economy, at 13 per cent of U.S. gross domestic product. Greece accounts for just 2 per cent of Europe's GDP.

Mired in partisan bickering, the state has shown itself incapable of managing its finances in recent years. It's now facing a $20-billion (U.S.) budget shortfall in the current fiscal year, and another big gap in 2011. Even with brutal planned cuts to government services and dramatic tax hikes, Republican Governor Arnold Schwarzenegger has asked for nearly $7-billion from Washington to fill the gap - a sum he is unlikely to get.

The shortfall equals a whopping 22 per cent of the state's GDP. That compares with a projected 10.6 per cent of GDP this year for the U.S. federal government's record deficit.

Like every state except Vermont, California is required by law to balance its annual operating budget. It can borrow money to build roads, schools and other capital projects. And it does have debt, with as much as $94-billion worth of bonds outstanding. But the ongoing expenses of government - education, health care, policing, jails, social services and the like - must be paid for out of this year's revenue.

The recession has decimated state income and sales taxes, leaving California unable to make ends meet. In a sign of growing desperation, it recently took the unprecedented step of issuing IOUs to some providers of services to the state.

The truly alarming part of this picture is that California, while the biggest budget buster among U.S. states, isn't alone. More than 40 states are headed for shortfalls this year, leaving them, cumulatively, with a record $194-billion hole to fill, equal to 28 per cent of total state budgets, according to a recent estimate by the Washington-based Center for Budget and Policy Priorities. And it's forecasting another $180-billion gap in 2011.

"In states facing budget gaps, the consequences are severe in many cases - for residents as well as the economy," the CBPP warned.

"Budget difficulties have led at least 43 states to reduce services to their residents, including some of their most vulnerable families and individuals. Over 30 states have raised taxes to at least some degree, in some cases quite significantly."

California, for example, is making deep cuts to basic health care, education and social services, as well as to its work force. State workers who keep their jobs face pay cuts of 5 to 10 per cent.

Tuition at some state colleges has shot up nearly 40 per cent.

All this weighs on the country as a whole because it pushes up unemployment and puts a drag on the recovery.

The Obama administration's stimulus package last year provided as much as $140-billion to help states maintain services between 2009 and 2011. But it's clearly not enough, and California's plea for more is running into a new mood of austerity in Congress.

"Perhaps the solution to California's woes is for Arnold [Schwarzenegger] to have California join the EU. Then, they might qualify for a bailout from Germany," joked Barry Ritholtz, chief executive officer of FusionIQ, which does stock market quantitative research.

The inescapable truth for the country is that the mounting toll of unmet state obligations - more than $350-billion in 2010 and 2011 - compounds the debt threat facing the United States. Foreign investors, who help finance all that borrowing, may not much care who the debt actually belongs to.

The market turmoil of recent weeks has forced Europeans to confront these linkages. In time, Americans will also realize that taking care of California, and other financially strapped states, is a national obligation.

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Follow on Twitter: @barriemckenna

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