Legislative Analyst's Office
February 1995

Perspectives on the Economy

The state's budgetary shortfalls in recent years have largely been due to the poor performance of the California economy. Employment declines, sluggish personal income growth, flat corporate profits, and a housing market collapse all resulted in very weak revenue performance during the early 1990s. This, combined with continued population growth and strong demand for state services, led to severe budgetary imbalances.

California's economy finally has “turned the corner” and is again expanding. It still has much ground to make up, however, before it regains its pre-recession peak.

The key questions at this point are:

This part discusses the economic outlook for the nation and California in 1995 and 1996, including the reasonableness of the budget's economic assumptions.

1994 in Retrospect

Figure 1 (see next page) summarizes national and state economic performance in 1994. The nation's overall economic performance was among the best in years:--

As the year ended, relatively rapid growth and low inflation were continuing. For example, in the year's final quarter the U.S. economy was growing at a 4.5 percent pace, inflation was barely over 2 percent, and unemployment was only 5.4 percent. Economic strength was broad-based, with good growth in both the consumption and investment sectors. Some signs were starting to appear (such as a decline in December retail sales) that the national economy might be slowing, however. --

California's Economy Rebounds

California's performance in 1994 continued to lag the nation's. However, its economy got stronger as the year progressed, and clearly was expanding at year end. Unemployment had dropped to 7.4 percent as 1995 began, the lowest level in four years. Personal income, employment, taxable sales and corporate profits all were rising.

The National Outlook for 1995 and 1996

Most economists are predicting that economic growth will continue in 1995 and 1996, although at a slower pace than 1994 and with a modest rise in inflation. Figure 1 (above) and Figure 2 indicate that the department shares this view. Continued gains in employment and corporate profits also are expected, along with rising interest rates, relatively stable unemployment and some softening in the housing market. --

Can a “Soft Landing” Be Achieved?

The main concern that economists currently have is that the nation's economy is nearing the point of full capacity, at which time inflationary pressures might take hold. As a result, economists generally expect interest rates to rise further in 1995 and early 1996, because of both increased inflation and overt attempts by the Federal Reserve (FED) to slow down the economy through restrictive monetary policies. For example, during the past year the FED has increased the short-term interest rates it directly controls on seven occasions, including earlier this month. Interest rates, however, are generally anticipated to remain well below their 1980s levels. Figure 3 shows that the department again shares this expectation. -- The main challenge and uncertainty in the national outlook is whether a “soft landing” can be achieved that balances continued moderate economic growth with modest inflation. Accomplishing soft landings has always been difficult. However, the task may be especially difficult to engineer today because of new uncertainties about the levels of unemployment and capacity utilization that can trigger significant inflationary pressures. --

The California Outlook for 1995 and 1996

Economic performance during 1995 and 1996 will be the single most important determinant of state revenues during the remainder of 1994-95 and 1995-96. About 40percent of 1994-95 revenues will depend on economic conditions during 1995, whereas about 60percent of 1995-96 revenues will depend on conditions during 1995 and 40percent on 1996 conditions.

Personal Income to Increase Moderately

No economic variable is more important in terms of overall economic performance and state revenues than personal income. Figure 4 shows how personal income has performed in recent years. During the 1980s, personal income growth averaged 8.3 percent in current dollars and 3.3 percent in real terms. During the recession (from 1991 through 1993), however, income growth was anemic, averaging only 3.4 percent in current dollars and 0.1 percent in real terms, including declines in both 1991 and 1993. Moderate increases then occurred in 1994, as the economy began to firm up. ----

Growth To Be Below-Normal for a Recovery

It is common that strong snapbacks in income growth occur during post-recession economic recoveries. This occurred following the previous recession, when real income growth averaged 5 percent. This is unlikely to happen in California in 1995 or 1996, however, due to such factors as a slowing national economy, continued defense spending reductions, prospects of additional military base closures, ongoing industry restructurings, and a soft housing market. It is more realistic to expect less-than-average, modest real income growth for California and, because of low inflation, only moderate nominal income growth.

The department's personal income forecast is consistent with this view--nominal growth of 6.6percent in 1995 (5.7percent if the effects of the 1994 earthquake are excluded) and 6percent in 1996, an average real growth of about 3 percent.

Real Per Capita Income to Increase Slightly

Real per capita income is a key indicator of economic well-being. It also is the principal determinant of consumer expenditures, which are responsible for about two-thirds of all spending, output demand and jobs in the economy. Thus, trends in real per capita income say much about the overall strength of the economy. Real per capita income growth depends on the relative rates of growth in total income and population.

Figure 5 shows that real per capita income growth was strong in the mid-1980s, grew little during the late 1980s, and declined for four years during the 1990s. This was due both to the recession and continued strong population growth. As Figure 6 indicates, population growth was especially strong during the late 1980s and very early 1990s, despite the weakening economy.

Income Growth Should Outweigh Population Growth. Real per capita income will increase in 1995 and 1996 as aggregate real income growth outstrips population growth. As Figure 6 indicates, population growth slowed sharply during the recession, partly because California's weak job market triggered increased outflows of job seekers to other states and reduced inflows from other states. As California's economy improves in 1995 and 1996, these trends should reverse and population growth will again pick up, although the increase should not be so great as to preclude some modest rise in real per capita income. Even after this improvement, however, 1996 real per capita income will still remain below its 1989 peak.--------

Employment-- A Lagged but Continued Recovery

Figure 7 shows that job losses during the recession were worse, and job recovery has been slower, for California than the nation:

-- California's relatively weaker job performance in the 1990s contrasts with the 1970s and 1980s, when California consistently outperformed the nation. --

Unemployment Gap To Remain

Unemployment rates further dramatize how badly California was hit in the recession. Figure 8 shows that the nation's and California's unemployment rates moved closely together throughout the 1980s. However, due to California's relatively larger job losses during the recession, California's rate rose much more and then declined later and by much less than the nation's. The state's rate currently is running about two percentage points above the nation's, and a gap of nearly one percentage point is expected to still remain at the end of 1996. Although the state's rate shot up to 8.2 percent in January from December's 7.7 percent, most economists attribute this to the heavy rains in January, and expect declines to resume over the coming months. --

Over 500,000 New Jobs To Be Created

There are two different ways that economists measure employment performance. The first is the number of people employed, which is forecast to rise moderately by 2.8percent in 1995 and 2.3 percent in 1996. These data come from a small survey. -- The second measure is the number of jobs, which recognizes, among other things, that people can hold more than one job. Many economists prefer to use the jobs data, in part because they come from a large survey, and include information about the types of industries where people are employed, the hours they work and how much they are paid. Job growth is forecast to be 1.8percent in 1995 and 2.5 percent in 1996. Figure 9 shows that this translates into 500,000 new jobs in 1995 and 1996 combined. --

Where Will the New Jobs Be?

Figure 10 shows that job growth will be highly concentrated in services and trade, and to a lesser extent construction. In contrast, manufacturing, government, and the economy's other sectors (like finance, transportation and utilities) will experience relatively slow job growth. For instance, Figure 10 shows that:

-- The service sector's large share of new jobs is a continuation of recent trends. Over the past eight years, service jobs increased by over 3 percent yearly and accounted for nearly three-fourths of the economy's total 1.1million job growth. This partly reflects California's importance as a center for financial services and high-tech activities that require highly trained service personnel.

Continued Declines in Aerospace

There are several reasons for the weak job growth expected in manufacturing, but one of the main factors involves the declines expected in high-tech jobs. High-tech jobs, which primarily involve electronics and aerospace, account for about one-fourth of all manufacturing jobs.

Figure 11 (see next page) shows that high-tech jobs fell by over one-third between 1986 and 1994, as more than half of the state's aerospace jobs were lost. Further aerospace declines are expected in 1995 and 1996, due to additional federal defense-related spending cuts. -- As Figure 12 shows, federal defense spending has fallen sharply since the mid-1980s, and now accounts for less than 6percent of the state's gross product. Further declines can be expected.

Housing Market Remains Fragile

Although direct employment in the construction industry accounts for only about 4 percent of all California jobs, its impact on the economy is considerably greater. This is because it gives rise to economic activity in many other sectors of the economy, including equipment and building materials, manufacturing, services and trade.

Figure 13 shows that California's housing market was especially hard hit by the recession and has only recently begun to recover. By 1993, new building permits had plummeted by over 70percent from their 1986 peak and per capita permits were the lowest in 25 years. Performance for multi-family housing has been especially anemic. In 1994, the housing market began firming up and experiencing a modest upturn,-- ------and additional gains are likely in 1995 and 1996. The market's strength will be constrained, however, by rising interest rates, the moderate overall pace of the economy, and above-average housing inventories.

Peso Brings Added Uncertainty

After the Governor's Budget was issued, the Mexican peso experienced a dramatic fall in value. President Clinton recently announced a $50billion aid package for Mexico in an attempt to “shore up” the peso and stabilize its value, aimed at keeping Mexico from slipping into a serious recession. The aid package includes $20billion in U.S. loans or loan guarantees to Mexico, and $18billion of International Monetary Fund credit. Mexico also would get $12billion in short-term credit from other nations.

Effects Will Be Negative

The peso's decline clearly will have negative implications for the U.S. economy, although economists currently are “across the board” in predicting their likely magnitude, ranging from minor to major.

The effects on California will be mixed, but on balance negative. On the positive side, Californians will enjoy lower prices for Mexican goods and services, and certain California firms with Mexican operations will experience improved profitability. On the other hand, demand by Mexico for California goods and services will decline, affecting California employment. The peso crisis offsets some of the gains to California from the tariff cuts under the North America Free Trade Agreement (NAFTA), at least temporarily. It will also exert some drag on Southern California's economy, especially cross-border retailing and tourism activities. Its ultimate impact, however, will depend on where the peso's value eventually stabilizes, what happens to foreign investment flows into Mexico, and whether California exports to other nations can backfill for reduced exports to Mexico.

Is the Budget's Economic Forecast Reasonable?

The department's basic expectation of continued though slowing national economic expansion with some increase in inflation and interest rates is shared by the vast majority of forecasters. In this sense, the department's national forecast is reasonable. The same can be said of its California forecast.--

Stronger National Growth Possible

Although the budget's national forecast is reasonable, we share the current view of many economists that 1995 economic growth could be a bit stronger than assumed in the budget. The main reason involves the unexpectedly strong economic performance at the end of 1994 and the momentum that this brought going into 1995, as well as continued commitment by the FED to achieve sustained growth without triggering significantly higher inflation. It should be noted that the department's economic forecast on which the budget's revenue forecasts are based had to be prepared well before relatively complete data on 1994's economic performance was available.

Figure 14 (see next page) compares the department's outlook with the slightly stronger outlooks that we and the Blue Chip consensus have for such variables as real GDP growth, corporate profits and housing starts.

California Forecast--Reasonable Given Risks

The department's California economic forecast also is reasonable, especially in light of the many uncertainties surrounding the outlook noted above. As shown in Figure 14, both the LAO and consensus forecasts expect slightly slower 1995 and 1996 personal income growth than the department, partly due to favorable inflation trends. Our outlook for employment growth and housing permits is a bit more optimistic for 1995, however, given recent strength in the economy, but less optimistic for 1996, given interest rate trends and defense-related factors. As discussed in Part Three, our forecasts for taxable sales and California's taxable corporate profits also are a bit more optimistic than the department's. The forecasts shown are fundamentally similar, however, in that they expect continued moderate economic growth with modest inflation.

Other Very Different Scenarios Also Are Possible

Of course, should the “soft landing” predicted by most economists not be achieved at the national level, California's outlook could take a turn for the worse. As of January, economists seemed to feel that the soft-landing, although the most likely outcome, has about a 50-50 chance of occurring. There are three major alternative national economic scenarios that realistically could occur:

What about the Long-term?

The long-term outlook for an economy as complex and diverse as California's depends on a great number of different types of individual factors. Some of the most important are demographic trends, labor force characteristics, rates of change in labor productivity, technological change, capital investments by businesses, the quantity and quality of different types of public infrastructure, the inflationary environment, perceptions about the state's “business climate,” economic and political developments in foreign nations that are our main trading partners, and societal factors. Also important are federal fiscal policies, including tax policies and budget-related developments involving such areas as state and local grants and defense-related spending.

Generally speaking, the outlook for California over the longer run is positive. Growth will not be spectacular, but most economists believe that reasonably good performance is likely.

Looking beyond 1996 and the immediate economic cycle, it is most likely that California employment growth will average in the range of 2 percent to 3 percent, given underlying demographic trends. Assuming inflation in the 3 percent range, personal income growth would average in the range of 5 percent to 6percent, with real income growth between 2 percent and 3 percent. Of course, actual performance in many individual years would lie outside these ranges, especially if a significant national slowdown or recession emerges within the next few years.


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