08/14/2009 05:12 am ET Updated May 25, 2011

Suffering in El Centro: Cigars in Sacramento

California's economy is in free fall. This appears to be of little concern to Governor Schwarzenegger, who instead prefers to focus his energy, attention and political capital on the ballooning state budget. So much time has he -- the economy seems not to require his attention -- that he regularly retires to a tent adjoining his office in Sacramento. Here he smokes pricey cigars with colleagues and gives interviews to, for example, the Financial Times about the state's budget deficit. From this lofty perch he recently announced that "The state and its people have to make major sacrifices. There are no two ways about it."

Perhaps if he were to leave his tent and stroll around the state, he might find that Californians are already making major sacrifices. Unemployment is soaring. The latest data from the Bureau of Labor Statistics (May 2009) shows that more than two million Californians -- 11.5% of the workforce -- are unemployed. In parts of the state governed by Mr. Schwarzenegger, the rate is much higher. El Centro recorded the highest unemployment rate in the country as a whole, at a shocking 26.8 percent. Among the 15 areas across the US with jobless rates of at least 15.0 percent, 7 are located in California, 3 in Michigan, and 2 in Indiana.

Things are no easier for California's middle classes -- many of whom must have voted for Mr. Schwarzenegger. The value of Californian properties has fallen by a whopping 43% since the peak of the credit-fuelled asset-price bubble.

Unemployed Californians and those facing foreclosure are reluctant shoppers. This is bad for business. The result: more bankruptcies and more layoffs.

And so the economic spiral spins perilously downwards, while Mr. Schwarzenegger retires to his tent and puffs on cigars.

The state budget has not escaped the impact of the crisis. As everyone with an Economics 101 knows, unemployment implies a loss of wages, and therefore cuts in tax payments. According to Governor Schwarzenegger's budget, personal tax payments made up 38% of the state's revenues in the past. A collapse in these payments -- unsurprisingly -- has led to a budget crisis. Because millions of Californians can't afford to shop on the scale they did before, the budget is also losing revenues from sales taxes. These make up nearly 30% of the state's projected budget income. Company bankruptcies mean that corporation tax revenues are falling too -- and these make up 10% of proposed budget income.

The obvious answer to the budget crisis would be to boost revenues -- and increase state income. This is best done by creating employment.

How to finance this, the wise reader asks? Well, Mr. Schwarzenegger has already hit on part of the answer. He has created money -- and named it "IOUs." That money is being used to pay salaries and suppliers. It is already being exchanged and traded. IOUs are a form of credit, and were created at will by Mr. Schwarzenegger.

In just the same way Mr. Ben Bernanke and the Federal Reserve have since the start of this crisis, created billions of dollars at will -- to bail out the banks. As the Fed Governor reminded us in March this year, the money to bail out the banks was not raised from taxation. Instead the Fed created credit out of the blue sky. Or to put it more accurately: by simply entering a number into a ledger. To quote Mr. Bernanke:

"The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed." (Italics added.) Ben Bernanke: CBS Interview 15th March, 2009.

Now Mr. Schwarzenegger is on the right path. But instead of going to the employees and suppliers of the state of California to ask for credit (or tax increases), he should go to the banks. Prompted by the Federal Reserve, the banks should be obliged to provide the state of California with credit -- at a cost no higher than their own minimal administrative costs -- say the cost of the computer into which the number is being entered, and the cost of paying staff for marking up the state of California's account. These costs are minimal, so interest on the loan should be no higher than say, 1%.

Using that money to stimulate economic activity in California -- productive economic activity that employs people in useful, valuable and fulfilling work -- Mr. Schwarzenegger would soon be raising the funds to pay off the deficit. Because rising employment implies rising tax revenues.

But as things stand, Mr. Schwarzenegger's solution is the polar opposite. It is Republican in tooth and claw. Namely: to force the people of California to "make major sacrifices, " by cutting budgets for jobs in the health and education sectors -- and by cutting back on services -- i.e. lowering meaningful economic activity and raising unemployment! (The bulk of the budget is spent on the salaries of staff working in Health and Human Services, and Education.)

In other words, Mr. Schwarzenegger wants to cut the legs off a failing economy -- in the hope of getting "the patient" to walk again. By exacerbating California's serious rate of unemployment he is encouraging further mortgage defaults, foreclosures and business failures -- and therefore bank failures. In other words, by demanding major sacrifices of the people of California, he is simultaneously proposing to worsen his state's budget crisis, by lowering personal income tax, sales, and corporation tax revenues.

This is the kind of economic lunacy that could only be contemplated by a man (and his advisers) detached from reality. But it sure is Republican. In Britain, and indeed throughout Europe, conservative parties are making the government deficit and budget cuts -- not financial failure, rising unemployment or climate change - - the biggest threat to civilization as we know it. Voters are invited, like turkeys, to vote for Christmas.

Someone should remind Mr. Schwarzenegger of the experience of the New Deal -- when President Roosevelt created jobs and cut the government deficit. Take care of unemployment, Mr. Schwarzenegger, and the state budget will take care of itself. The budget will recover its balance when the economy recovers. As sure as night follows day.

This time, employment should be geared towards preparing California face the threat of climate change. In other words, the economy should be oriented away from mere consumption -- shopping -- and instead be geared towards cutting consumption, conserving nature's assets and developing human resources. This would help save Californians from extreme weather events, while improving their sense of fulfillment and well-being. In other words, California should be embarking on a Green New Deal.

When Californians are put to work e.g. to de-carbonise the economy and grow California's human resources (through education/the arts/health services etc.) then something extraordinary will happen. More Californians will a) pay state taxes b) pay off mortgages c) pour income into local businesses and c) stabilise the banking system. When that happens, Mr. Schwarzenegger will find -- no doubt to his surprise -- that the budget returns to balance.

But only then.