We are all "Petro-States" now

I have been reading Daniel Yergin's new book, The Quest: Energy, Security, and the Remaking of the Modern World. In Chapter 5, entitled "The Petro-State," Yergin describes the ailments that afflict countries (for example, Venezuela) that are primarily dependent on oil revenues for national income. Yergin writes:

When [oil] prices soar, governments are forced by society's rapidly-rising expectations to increase their spending as fast as they can -- more subsidies to hand out, more programs to launch, more big new projects to promote. ... But when world oil prices go down and the nations' revenues fall, governments dare not cut back on spending. Budgets have been funded, programs have been launched, contracts have been let, institutions have been created, people have been hired. Governments are locked into ever-increasing spending. Otherwise they face political and social explosions.

What struck me about this passage was not that it was an insightful description of Venezuela and other Petro-States (which it is), but that it was a description that could be generally applied to the recent crises of so many governments around the world. For example, Michael Lewis describes the similar plight of the city of San Jose, California in his new book, Boomerang: Travels in the New Third World

The problem, [San Jose mayor Chuck Reed] explains, predates the most recent financial ciris. "Hell, I was here. I know how it started. It started in the 1990s with the Internet boom. We live near rich people, so we thought we were rich." San Jose's budget, like the budget of any city, turns on the pay of public safety workers: the police and firefighters now eat 75 percent of all discretionary spending. The Internet boom created both great expectations for public employees and tax revenues to meet them. ... Over the past decade the City of San Jose had repeatedly caved to the demands of its public safety unions. In practice this meant that when the police or fire department of any neighboring city struck a better deal for itself, it became a fresh argument for improving the pay of San Jose police and fire.

In other words, the phenomenon described by Yergin is not at all limited to countries whose primary source of revenue is oil. Rather, a more general description of the phenomenon can be given as follows: A boom in some segment of the economy (global oil prices for Venezuela, the value of Internet stock options for San Jose) causes an increase in tax revenues for the state. The state, flush with cash, spends these new revenues on lavish social programs for its citizens and lavish pay and pension packages for members of public service employee unions. The state locks itself in to obligations to continue paying for these programs and pay/benefits regardless of the future condition of the economy. The boom then ends, the gusher of tax revenues dries up, but the state is still left with its long-term obligations, which it now cannot pay. The beneficiaries of these programs, ordinary citizens and public service union employees, having grown accustomed to and dependent on government largesse, rebel at any suggestion that spending be cut back.

Under similar circumstances, private markets adjust: private companies lay off workers and cut back spending; in the worst case, they declare bankruptcy and abrogate the fixed obligations they are not able to meet. In the public sector, however, there are obstacles, political and legal in nature, that prevent govermental entities from declaring bankruptcy. Given the high degree of fiscal rigidity in politically supported social programs and labor contracts, government is unable to adapt, it cannot cut back. Fiscal crisis ensues.

This is the situation so many governments around the world find themselves in today. Besides California and Venezuela, we can see a similar situation in Greece. There the boom was not in oil or stock options, but in credit. The Greek government, flush with the proceeds from bonds it had issued at the same interest rate as its more financially conservative neighbors, expanded the public sector dramatically. Now credit has dried up, but the government is still obliged to spend, but cannot, and seeks to cut back on the salaries of public employees. These employees, having become dependent on the government, rebel. The result is the riots we have seen in Greece, the precursors of similar riots we are starting to witness with the Occupy Wall Street crowd here in the United States.

Here in the United States, we used to laugh at the financial trials and tribulations of "Third World Countries." Now it is our turn to be laughed at. We are all Petro-States now.