Recovery in the Golden State
Rebounding from a cyclical recessionAugust 8, 2009
Recessions, whether regional or national, typically are driven by a rapid reduction in one or more sources of demand. For example, the 2001 recession was driven by a sharp pullback in business investment as a result of the collapse of the capital markets. When this occurs, investors and people employed in that sector of the economy must direct their efforts elsewhere in the economy. This process takes time as unemployed people look for new work and businesses seek new markets. This response creates an additional reduction in local economic activity, generating a vicious cycle that magnifies the initial shock.
Despite the credit normally taken by political leaders at the end of a downturn that they “fixed” things, in reality growth is the default mode for a normal economy. Therefore, these underutilized labor and business investments eventually will be reemployed and the economy will get back up and running without help from anyone. This is not to say that policy can’t help (or hurt) the situation — only that the situation will eventually work its way out of the downturn. The big question is the speed and intensity of the recovery. This becomes a function of many things, but three are most important:
- The size of the initial shock
- Whether the shock is structural or cyclical
- Government policy
We will look at each of these points in turn, particularly as they relate to California.
The size of the hit to the United States economy in the current downturn was enormous, and is attributable to three sources. The first source of this recession was the housing market, in which home prices relative to incomes went to levels never seen, and the pace of construction reached levels far beyond the point of sustainability. While this was the first source to break, it was not the largest issue. Indeed, we moved through the first year of the housing downturn without much problem.
The second issue was the enormous asset price/debt bubble in the U.S. economy that occurred between 1994 and 2007. Not just homes, but also bonds, commercial real estate, stocks — almost any sort of financial asset became overpriced in this speculative binge. Asset values in the U.S. economy grew at a much faster pace than productivity — a situation that also was an unsustainable trend. Consumers and businesses used this collateral to amass a huge amount of debt. The asset bubble is now collapsing and much of that debt cannot be collected, putting enormous pressures on the financial system.
The third source was the American consumer, who stopped saving while that bubble of asset price and debt was inflating. Enormous asset wealth and expectations of asset appreciation that were out of whack with reality caused savings rates to fall from 9 percent to 0 percent over the same period. This drove a huge national trade deficit: 6 percent of the gross domestic product at the height of the bubble.
California was front and center on all these trends. We saw home prices increase more than anywhere else, the pace of home building accelerated relative to population growth and consumers here borrowed more against their homes to enjoy a lifestyle beyond their means than most anywhere else in the United States. On top of this, California saw its ports and factories thrown into high gear as demand for goods across the nation surged. Now, with things breaking, the state is experiencing a worse than average downturn in terms of job losses and home foreclosure rates, and it will likely find the local banking sector to be hardest hit. This spells a longer, deeper downturn for California than for other states.
The second major driver of the speed of a recovery is whether the hit to the economy is structural or cyclical. A structural shock is one that never really recovers. For example, the aerospace industry in California was permanently downsized in the early 1990s as a result of a sharp cutback in federal defense expenditures, collapsing demand for civilian aircraft and the relocation of the remaining facilities to places where it was cheaper to do business.
This time around, the problems in California are largely cyclical — in other words, the downturn is occurring in parts of the economy that eventually will recover. For example, while housing is down, we know that population growth eventually will create the demand for new homes, rejuvenating employment and investment in the industry. Similarly, cutbacks in consumer spending also eventually will be reversed. These reversals mean that the recovery will be quicker and sharper than in the ’90s, at least once we adjust for the much larger size of the current downturn’s initial shock.
Indeed, several years ago California had two structural problems in its economy that we managed to largely ignore, given the economy froth driven by excessive consumer spending and the boom in asset prices. Our first big problem was that housing was too expensive for the state to effectively compete for workers in the national labor market. Many middle-class families were fleeing the state for cheaper locations. The second major issue was the high value of the U.S. dollar, driven in part by the trade deficit. California is a very export-oriented state. It’s not just ports and manufacturing: the state’s firms earn huge proceeds from overseas licensing of intellectual property, from movies to software. Additionally, the state is one of the top spots for foreign tourism.
The good news is that the collapse of the bubble has removed these structural problems. Homes are affordable again, which means our businesses will be more competitive within and outside the United States. The increase in the U.S. private savings rate means the value of the dollar eventually will have to fall again to allow the external accounts to re-equilibrate.
These factors both promise a strong recovery in the local economy, once the current problems are worked through. In short, the cyclical part of this recession is much worse than what we saw in 1990, but the recovery will be much stronger once we reach that point in the cycle over the next two years. An export boom and strong migration into the state will help the economy and incomes grow sharply in 2011.
The third factor affecting the speed of economic recovery is government policy. The Great Depression in the 1930s was as much driven by bad policy as by the initial shock to the economy, allowing banks to fail and the money supply to collapse — not to mention setting off a global trade war.
This time, policy has been much more aggressive. Quantitative easing by the Federal Reserve System, tax cuts and bailout programs financed by large federal deficits, and extensions of unemployment benefits all have served to help reduce the extent of the downturn. But here we need to worry about the long-run effects of these actions. Quantitative easing has increased the monetary base sharply, and the national deficit has been growing at an alarming rate. Local governments have been a victim of the downturn. Unwise spending in times of plenty has led to a famine. Instead of finding new revenue sources or finding a way to reduce the costs of providing services, the state is purging many programs and slashing others that are important for the long-run health of the California economy.
The question we need to ask now is how long California’s recovery will last if the next large crisis is a substantial increase in tax rates — or even worse, a serious bout of inflation or a spike in interest rates driven by the fight against it. It also remains to be seen if the massive cuts in local spending on health and education will create a new social crisis that will hurt the state, not unlike high home prices did. Only time will tell. What is clear is that California retains all the advantages we might want in the United States — if we do not squander them.