FYI Article Taken from the State Controller's Newsletter

Economic Reality: California Being Hit From Two Directions

By Christopher Thornberg
Founding Principal, Beacon Economics
Chair, Controller’s Council of Economic Advisors

The budget problems in California are currently some of the worst in the nation, leading many to ask how much the economy is to blame for the shortfall. In the short span of two years, California’s General Fund budget has declined from $102 billion to $86 billion. Is California mired in a worse cycle than the rest of the nation, and is that in turn driving the worse-than-average state and local budget problems?

The answer is, yes, the state is facing a harsher economic crisis than most other areas of the nation. California is at the crossroads of the two primary drivers of the national downturn, feeling both the collapse in employment in traditionally cyclical industries such as construction and manufacturing, while also suffering from a greater-than-average decline in asset values, which drives down consumer spending faster than the national average.

Consider first the primary evidence of the state’s economic downturn: California’s low-performing labor markets. While the peak in national payroll employment occurred in December of 2007 – roughly the time the recession began – California’s payroll had already began to drop six months earlier. The nation has shed just over 4% of its labor force to date, while California employment is down by almost 5%.

Unemployment also reflects the difference between California’s and the national economy. In California, unemployment has risen by over 6.5 percentage points, compared to 4.5 percentage points for the nation overall. At 11%, California’s unemployment rate is the fourth highest in the U.S. It is hardly surprising that California has seen a sharp drop (down 7.5% as of April 2009) in its personal income tax collections, particularly given the progressive nature of its tax structure. The severity of the economic impact is in part due to California’s exposure to the housing bubble. Few other states saw the same rise and fall in prices, or the same degree of expansion and contraction in construction and related employment. California’s housing market was thrown into a tailspin by the mortgage industry debacle that unfolded over the past three years. By our estimates over a third of all subprime and Alt-A lending (by value) took place in California, causing a huge surge in construction and home prices. Now, at the back end of the real estate debacle, California is suffering worse than many other regions. The collapse in new construction has already taken a harder toll on the state: Permits for residential construction are off 86% from their peak, compared to 70% for the nation overall. Nonresidential construction permits also fell sharply over the past year. Together, these two trends have caused the state to lose 26% of its construction jobs, compared to 16% for the nation overall.

As a result of the influx of subprime lending, the state is going through a severe foreclosure crisis that makes a quick turnaround in this sector seem unlikely. Three percent of all households in the state have been foreclosed on, and another 600,000 to 800,000 homes could meet the same fate in the next two years. This not only displaces families, but puts a strain on local authorities who must deal with empty structures, crime and blight.

The labor problem in California will continue to worsen in the coming months. The other major cyclical sectors – manufacturing and transportation –have held close to national trends. Yet while banking and housing have come close to a bottom, there has been a sharp collapse in both exports and imports in recent months. California’s economy is closely tied to trade: More manufacturing exports come from this state compared to others, and Los Angeles County’s two ports combined are some of the largest in the world. This stress on trade will continue to add to the state’s labor woes.

The other side of the nation’s economic problem is consumer spending. Savings rates in the U.S. dropped from 9% percent in the early 1990s to nothing in 2005 as high asset price appreciation gave Americans a false sense of financial security. When assets lost value, Americans started to do what they should have done all along – save. Here again, California is finding itself hurt worse than other states.

Consider the most basic source of household wealth – homes. Prices in California have already fallen 40% from their peak, as opposed to slightly more than 25% for the nation. Given California’s high home prices at the market’s peak, the asset loss can be three times greater for the California homeowner than it is for the average American.

This large asset loss has affected the state’s consumer spending. Taxable sales in California were down 11% in the fourth quarter of 2008, compared to just a 5% decline in nominal spending on all durable and non-durable goods and an 8% percent drop in retail sales nationwide. It is no surprise that California has lost 7% of its retail workforce, compared to an average 4% loss for the nation overall.

California has a fundamentally strong economy and will surely recover in the coming years, but the depth of its current problems cannot be underestimated. It will take a number of years for the economy to fully recover from this downturn and, as a result, so too will state revenues take time to recover.