Sound economy, empty coffers: state's budget deal depends on leap of faith to bridge gap.

Borrowing billions of dollars to keep state government afloat has become the latest tradition in California, as seen by last week's adoption of a budget containing $14 billion in long-term borrowing.

The question is, will California's economy be able to ride to the rescue--as it did in the mid-1990s--to cushion the blow when the bills come due? Or will continued reliance on borrowing this year and in future years cause long-term damage to the economy?

The prevailing view is that the red numbers this time around are simply too large for growth alone to make up the difference and bail out the state budget without more tax increases or deeper spending cuts.

"Even though our economy may outperform the national average over the next several years, it will not be nearly enough to grow our way out of this budget problem," said Stephen Levy, chief economist with the Center for the Continuing Study of the California Economy in Palo Alto.

Under the agreement reached last week, the 2004-05 budget is already $8 billion in the red. And that could grow much worse if revenues again fall short of projections.

Levy and others say revenues will have to register double-digit increases for several years to make up for the likely budget gap. Traditionally, revenue growth has hovered in the mid-single digits; only during the Internet bubble of the late 1990s did revenues grow by more than 10 percent.

But that doesn't necessarily mean the sky is falling.

Edward Leamer, professor of business economics and director of the UCLA Anderson Forecast, said that another year or two of spending cuts in the $5 billion to $7 billion range, combined with average revenue growth, could close much of the gap without having to borrow billions of dollars more each year.

"The key is to make those additional reductions and then hold the line on spending at those reduced levels while revenues slowly increase," Leamer said. "That would give us a relatively slow reduction in spending over several years, which is probably the best outcome that can be expected."

But, Learner cautioned, that would only take care of the $8 billion to $10 billion annual structural deficit for future years, not the $25 billion to $30 billion in debt accumulated to this point. The structural deficit is the result of an imbalance of revenues and expenditures as state spending on new programs shot up in 1999, 2000 and 2001.

"Deficit financing now may be desirable given this weak economy, but it means that taxpayers will have to make up this burden later on," he said, pointing to the prospect of higher interest payments on bonds.

Much is in flux, of course.

There is the possibility that the just-approved budget might have to be re-opened. The budget relies on $4.4 billion in additional revenues from an increase in the vehicle license fee; that increase, which was implemented unilaterally by state finance officials, is being challenged in court by the Howard Jarvis Taxpayer Association and several Republican lawmakers.

Also under legal challenge is the plan to roll over $11 billion in debt through the issuance of "deficit reduction bonds." The Pacific Legal Foundation is preparing a lawsuit that claims the state constitution does not allow any bond measures exceeding $300,000 to be approved without a vote of the people.

If the current budget deal stands, debt levels might be aggravated if the Legislature next year resorts--again--to borrowing. "Despite all the rhetoric out there, there is no consensus--either among lawmakers or the public at large--for cutting services significantly," Levy said.

That means if the Republicans hold the line on increasing taxes, a similar standoff could once again be in the offing next year. That, in turn, increases the temptation to borrow.

Plus, there's the possibility of a new governor taking office should Gov. Gray Davis be recalled on Oct. 7--and with it, a possible overhaul in the state's finances.

The biggest wild card could be an initiative petition now circulating for the March 2004 primary ballot that would reduce the legislative vote threshold for budget passage from the current two-thirds majority to 55 percent.

If this initiative petition gets the required 600,000 signatures and gets a majority voter approval, then Democrats would have enough votes on their own to pass a budget, thus eliminating what has become an annual ritual of partisan gridlock. That budget would presumably include some tax increases.

"That's the main gamble Democrats were counting on during this budget debate: if they just put off the tough decisions one more year, they could get that tax increase passed next year," said Ted Gibson, a private consultant and former chief economist with the state Department of Finance who provided the economic forecasting behind eight state budgets.

Stuck near junk

If that initiative falters, then there will be an increased temptation to again borrow to close the gap, Gibson said. However, he said it could be more expensive to sell additional bonds, particularly if the state's bond rating does not improve.

Last month, Standard & Poor's reduced its rating on California general obligation bonds from "AAA" to "BBB," the lowest rating of any state and just one grade above junk bond status. And despite passage of the state budget, S&P Director David Hitchcock expressed doubts last week that the lowered rating would be adjusted upward anytime soon.

The issue is not the marketability of the bonds, per se. Some analysts, in fact, expect demand for California bonds to pick up as a result of the higher interest rates.

"There's a price at which you can sell anything," Gibson said. "The question is, how high are you willing to go? If the price goes high enough, some government agencies may decide it's not worth it to fund certain projects."

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And that, economists say, is the main risk of relying too heavily on borrowing to close successive state budget deficits. So far, they say, the borrowing is at manageable levels. But if there are significant new bond offerings not currently anticipated, that could change.

"As these interest rates go up, there's less money available in government budgets for other needs, particularly in infrastructure investments," said Esmael Adibi, director of the Andersen Center for Economic Research at Chapman University.

Also, if the price is too steep, government agencies might put off projects they might otherwise have gone forward with. Although the state did recover from the last state budget crisis of 1991-92 with little lasting damage, there are two significant differences this time around.

First, then Gov. Pete Wilson immediately proposed--and pushed through the Legislature--a package of $7 billion in tax hikes and $7 billion in spending reductions to close a $14 billion hole. Long-term borrowing was not a significant feature of that plan.

Also, the recovery from that early 1990s recession turned into the most spectacular revenue boom state government has ever seen, a boom that almost everyone agrees won't be repeated anytime soon. In the 1999-2000 fiscal year, state revenues jumped a record 21 percent, more than four times the historical average increase. Much of this increase came from taxes paid on stock options awarded to employees and investors in high tech companies.

California already lags other states and highly developed countries in maintaining its infrastructure, from roads and bridges to new schools. Without significant new investment, that gap will likely widen, economists say.

--Bloomberg News contributed to this story