II Perspectives on the Economy and Demographics

Part I

Economic and demographic developments are extremely important factors in California's budget outlook. For example, the strength of California's economy is the single most important determinant of the levels of collections from personal income taxes, sales and use taxes, and corporate income taxes. Similarly, California's population and economic trends affect spending in many of the state government's key program areas, including health and social services, education, and youth and adult corrections.

In the early 1990s, the downturn in California's economic performance contributed to major revenue reductions which led to substantial budgetary shortfalls. More recently, just the opposite has occurred--the state's economic recovery has resulted in healthy growth in General Fund revenues, which in turn has contributed to significant improvements in the state's fiscal condition. The Governor's proposed budget for 1998-99 assumes that continued, though moderating, economic growth will characterize California over the next 18 months.

In this part, we review recent economic and demographic developments, discuss the forecasts contained in the 1998-99 Governor's Budget, and provide our own perspective on California's economic and demographic outlook.

Background--A Perspective On California's Economy

California's Economy Is Large and Diverse

With total economic output exceeding $1 trillion last year, California's economy is the seventh largest in the world. The state's economy also is arguably the most diverse in the nation, with workers employed in a wide variety of different industries.

As shown in Figure 1, about one-third of the state's jobs are in the broadly defined services sector, which includes such diverse industries as computer and software design, motion picture production, hotel and travel services, engineering, business and professional services, landscape design, and auto repair. About one-fourth of the workforce is in the trade sector, which includes retailers, wholesalers, and import-export firms. An additional one-sixth each is in manufacturing and government. The remainder of California's jobs are spread among the construction, finance-related, transportation, utilities, and mining sectors.

Major Changes Have Occurred In California's Economy During the 1990s

The state's economy has undergone major changes over the past eight years, including a major recession, the permanent downsizing of some industries, and the emergence and growth of others. Figure 2 shows the net impact of these changes on the state's major industries.

It shows that most of the net increase in California employment in the 1990s has been in the state's services-related industries. Within the broadly defined services sector, many of the new jobs created have been computer-related positions in the business services subsector. Significant employment gains also have been experienced involving motion picture production, as well as in the "other services" category. The latter includes amusement and recreation, health services, engineering, biotechnology, and management consulting activities.

The nonservice industries showing significant employment increases include computer and electronics-related manufacturing, wholesale and retail trade, transportation, communications, and utilities.

The majority of job losses in the 1990s have been in aerospace manufacturing. This industry, which includes producers of aircraft, missiles and other navigation systems, has lost 177,000 jobs, or more than two-thirds of the aerospace manufacturing jobs that existed in 1990. Military base closures are primarily responsible for the 100,000 decline in federal government employment between 1990 and 1998. Consolidations of major California banks were responsible for the 60,000 job decline in the finance, insurance, and real estate industry subsector. Despite recent gains, construction employment also has experienced a net loss in employment in the 1990s. The 50,000 jobs lost in construction are due to declines in residential building activity during the decade (relative to levels in the 1980s).

Are the New Jobs of the Same "Quality" as Jobs in the Past?

An often-asked question is whether the new jobs created in California in recent years are of the same quality and pay level as those lost in the recession. The answer is somewhat mixed. The downsizing of the aerospace and banking industries resulted in the loss of many middle-income and upper-middle-income jobs in the early 1990s. In contrast, the new jobs being created in California's current economic expansion include a diverse mix of jobs at both the high and low ends of the income scale. Among the high-paying jobs are those being created in areas of computer and software design, and motion picture production. Among the lower-paying jobs are part-time jobs being created in areas of temporary employment services, retail trade, and tourism-related services. The net impact of these changes is that, while the average pay (in inflation-adjusted terms) of the newly created jobs may not be all that different from those lost during the recession, the distribution of pay levels has widened. That is, there are relatively more jobs now at both the high end and low end of the pay scale, and relatively fewer in the middle, than before.

Recent Developments

1997 Was a Strong Year

The economic expansion accelerated at both the national and state levels in 1997. The U.S. real Gross Domestic Product (GDP) increased by nearly 4 percent, the strongest gain of the 1990s. Despite healthy growth and an historically low rate of unemployment, inflation remained low, and interest rates fell over the course of the year. The past year also was very positive for California's economy, where personal income increased nearly 7 percent and wage and salary employment was up 3.5 percent.

Figure 3 summarizes the major features shaping California's near-term economic outlook.

Figure 3
Major Features Shaping California's Economic Outlook
California currently is enjoying strong growth and low inflation:
  • Continued improvement in job growth.
  • Broadening expansion.
  • Long-awaited recovery in home building.
However, Asian financial problems will likely affect future growth:
  • Lower demand for California exports.
  • Less tourism in U.S. from Asia.
  • Losses on U.S. investments in the region.

Job Growth Currently Strong. The recent performance of California's economy has been stronger than was assumed in previous forecasts made last year. As indicated in Figure 4 (see next page), wage and salary employment in the last three quarters of 1997 was up strongly from the prior year. The updated increases shown in the figure are greater than assumed in both the 1997-98 Budget Act forecast, and the Governor's January 1998 budget economic forecast. These upward employment-growth adjustments indicate that the California economy ended 1997, and is beginning 1998, with considerable momentum.

Expansion Has Spread to All Regions and Industries. California's recent job growth has been broad-based, with major gains in services, construction, retail trade, and computer and electronics manufacturing. Regionally, continued job growth has occurred at a strong pace in the San Francisco Bay Area, and gains have accelerated in southern California--where growth had lagged in the earlier stages of the expansion.

Residential Construction Finally Rebounding. Permits for new construction in California during 1997 were up by 18 percent from the prior year, reflecting gains in virtually all regions of the state. Key indicators point toward further gains in home sales and construction in 1998. For example, home prices in California rebounded 10 percent in 1997, which is a sign of renewed confidence and activity in the state's real estate markets. As shown in Figure 5 (see next page), home price appreciation has been strongest in Santa Clara County, the San Francisco Bay Area, and Orange County. However, the gains are now extending to all regions of the state.

Interest Rates and Inflation Low. Despite the fact that the U.S. economy has been operating at near full capacity (reflected in part by a very low unemployment rate and reportedly tight labor markets), inflation has remained remarkably low. The U.S. Consumer Price Index (CPI) was up just 1.7 percent between December 1996 and December 1997, and other measures of inflation show similarly low increases. Although wages have started to rise in response to tightening labor markets, these increases have not yet been translated into higher product prices. In response to the positive news regarding inflation, U.S. long-term interest rates declined over the past year, with the yield on 30-year Treasury bonds falling to below 6 percent at year-end. These low interest rates will give an added boost to home construction in the state. Lower monthly mortgage payments resulting from the refinancings of existing mortgages also will add to consumer discretionary incomes in 1998, further bolstering consumption spending in the state.

In summary, California is entering 1998 with considerable momentum, with jobs and income expanding at a healthy pace. The greatest known threat at this time to this otherwise bright outlook relates to Asia's financial and related economic problems. Given the potential threat to California associated with Asia, we discuss below in more detail the topic of Asia's financial crisis, including its implications for California in 1998 and 1999.

Asia's Financial Problems

Over the past several months, Korea, Malaysia, Indonesia, and other emerging economies in Asia have been beset by major financial and economic crises, characterized by significant business losses, loan defaults, bank failures, and declining stock market values. Most analysts attribute Asia's problems to the over-direction of investment funds by governments and central banks in the region toward favored businesses and industries. This eventually led to economic imbalances, mounting investment failures, and loan losses. These factors have caused international investors to "pull back" from the region, which has, in turn, led to major currency depreciations and further financial and economic problems in Asia. Major loan losses have also led to insolvencies in Japanese and Hong Kong investment houses, and have raised the risk that these problems will spread geographically beyond just the emerging Asian economies.

Impacts on California--Negative on Balance. Figure 6 (see next page) summarizes the principal ways in which Asia's problems could affect California.

Figure 6
How Asia's Problems

Could Affect California

Negative Factors
Investment losses and negative wealth effects
Reduced exports
Greater import competition
Loss of tourism
Possible Mitigating Factors
Reduced wage costs of foreign California-owned subsidiaries
Lower product prices, generating consumer savings
"Excess demand" in some affected industries, insulating them from near-term job losses

As indicated in the figure, there are four main negative effects involved:

Mitigating Factors. In evaluating the net adverse impact of Asia's problems, it is also important to take into account mitigating factors which tend to reduce the net effect on California:

Asian-Related Problems Expected to Slow But Not Stall California's Expansion. Overall, we estimate that financial and economic problems in Asia will depress employment and income growth in California by between 0.5 percent and 1 percent per year in 1998 and 1999. However, as indicated above, the state is entering 1998 with considerable momentum, so even after accounting for the negative effects of Asia, the state should register moderate economic growth over the next two years. The "bottom line" is that, while Asia's problems do pose a risk to California, they are but one of several factors shaping the outlook for the next two years.

The Governor's Budget Economic Outlook in Brief

The budget assumes that both the U.S. and California economies will experience ongoing, though tapering, economic expansion during the next three years, accompanied by continued modest inflation. As shown in Figure 8, the budget forecast projects that U.S. real GDP will increase by 2.7 percent in 1998 and 2 percent in 1999, following a 3.8 percent gain last year. In California, wage and salary employment is projected to increase 2.8 percent this year and 2.3 percent in 1999, while personal income is forecast to grow by 6.3 percent and 6 percent over the two years. The budget assumes that state employment and income growth will continue to exceed the nation in both 1998 and 1999.

Figure 8
Summary of Department of Finance's Economic Outlook
Percent Changesa
Preliminary 1997 Projected
1998 1999
United States Forecast
Percent change in:
Real GDP 3.8% 2.7% 2.0%
Pretax corporate profits 7.3 4.6 -0.4
Unemployment rate (%) 4.9 4.7 4.9
Federal funds interest rate (%) 5.5 5.9 6.5
California Forecast
Percent change in:
Personal income 7.2% 6.3% 6.0%
Wage and salary jobs 3.1 2.8 2.3
Taxable sales 5.9 4.8 4.3
Consumer Price Index 2.2 2.6 3.4
Unemployment rate (%) 6.3 5.6 5.4
New housing permits (000) 110 130 126
aUnless otherwise indicated.

Effect of Asia. The administration indicates that its forecast includes a slightly greater than 0.5 percent downward adjustment to the rate of growth in personal income in both 1998 and 1999 to reflect the net impact of the problems in Asia.


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