A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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Memo to Governor Paterson
Dont wait for the Wall Street crisis to worsenstart cutting now.
18 March 2008
As David Paterson succeeded Eliot Spitzer as New Yorks governor yesterday, he referred to Wall Streets continuing meltdown and noted that our economy appears to be headed toward crisis, adding that hed meet with government and business officials to adjust the budget accordingly. Assuming this means budget cuts, he should stick with the strategy, despite likely pressure from others in Albany.
Its probable that the governor will hear from legislators and lobbyists wholl argue that we dont know yet whats going on with the financial world. One day the markets up 400 points, another day its down 200. One day the talking heads are saying the crisis is over; the next day, huge investment bank Bear Stearns is going under. Given the uncertainty, Paterson may face pressure to avoid major changes for now and instead go forward with Spitzers proposed spending increases despite a $4.5 billion deficitwhether through borrowing, a temporary tax hike, or boththereby placating lobbyists and their constituents. Next, stand by and hope that Wall Streets problems mysteriously go away as mysteriously as they appeared, as sometimes happens.
But sticking to the status quo would be wrong, and ultimately far riskier than striking out in a new direction. Forget subprime mortgages, credit crunches, derivatives counterparties, and everything else. Just remember one thing about the state budget as it relates to Wall Street: assets create income. The state government gets its incometax revenue, that isfrom New Yorks private-sector assets, and the largest concentration of those assets is in New York Citys financial industry. The trillions of dollars that Wall Street has lent to homeowners, commercial builders, buyout companies, and the like are assets, because Wall Street uses the profits from those loans to make new loans and employ tens of thousands of people. The value of the stock market is an asset. But financial firms and their workers are the biggest asset of all: the companies and people who are constantly thinking up new financial-industry products to make new profits and send new tax revenues straight to Albany.
Right now, the value of all of these assets is plummeting. Banks have seen $150 billion in assets vanish because of the crisis that began in subprime mortgages; the market thinks many of those assets are now worth almost nothing. Bear Stearnss plight is another example: it was worth $20 billion a year ago, but J. P. Morgan and the Fed think its worth only $250 million today. More pain is coming because banks and their customers became reckless with lending and borrowing, and overconfident in their mathematical models, in an era of record-low interest rates as well as super-powerful computing. Before its all over, well probably see hundreds of billions of dollars more in big asset write-downs on credit cards, commercial-building mortgages, and corporate debt.
Whenever Paterson hears the term asset write-down or asset fire-sale, he can be sure that New York will have a little less money to spendnot just this year, but probably indefinitely. The possibility of a protracted downturn for New York is very real, because the falling value of assetsmortgages, stocks, and so onisnt even the worst part. As the banks see the value of todays assets fall, they have less money with which to create new assets. They cant invest in new people or new products; they cant even keep the old people or products around.
Plus, the investors whom those banks need to replenish their assets are rethinking the value of the banks human capitalthat is, of New York States most lucrative assets. Theyre wondering: if these bankers screwed up so badly, how much are they really worth? Is this industry worth any more of my money? It may take the financial world a long time to win back the trust of its investors and customers. Until it does, New Yorks asset base will continue to suffer severely.
To see what that means for state spending, think of Wall Streets assets as a trust fund that supports New York States spending, just as trust funds support the spending of some wealthy people. If the assets in a wealthy persons trust fund stopped growing and even started losing value, that persons investment adviser would say: Youve gotten used to spending a lot of money each year, but youre going to have to cut back now, because your assets arent generating as much income as they used to. Youre not going to like it, but its better to cut back a bit nowsay, 5 percentthan to have to cut back three times as much next year. What if the client doesnt listen? To fuel his excessive spending, hell have to sell off assets. By selling assets, hes hurting future income. And he cant do that foreverhe is only delaying future pain.
Its the same thing with New York State. If Governor Paterson chooses to go along with what the legislature might pressure him to do, and tries to borrow and tax his way out of this crunch, its no different from selling off ones good assets to generate income today at the expense of the future. Raising taxes on the wealthy, for example, will push some high-income New Yorkers to leave. Borrowing for operating expenses similarly hurts assets, because every dollar we borrow to plug a deficit is a dollar that we dont invest in vital infrastructure like roads and bridgesassets that help the private sector create future income.
The prudent thing for Governor Paterson to do is to start cutting spending now, to give the states private-sector assets a chance to recover. If the state recovers quickly, the worst that would happen is that next year or the year after, hell have to fend off the same lobbyists who will be back to push for yet higher spending. But if New York doesnt recover quickly, delaying action now will only make recovery that much more difficult.
Nicole Gelinas is a contributing editor to City Journal and a Chartered Financial Analyst.