Author: Bill Watkins

No, It’s the Deniers who Are Wrong

Dennis Meyers is the Principal Economist at California’s Department of Finance. He has recently published two parts of what is promised to be a four-part series titled The Declinists are Wrong. He intends to convince us of “the fundamental strength of the Golden State’s dynamic and vibrant economy.”

I was going to wait until the entire series was complete before commenting, but part one and part two are so poorly argued that I feel compelled to respond now.

In part one, Meyers argues that California’s economy is strong because it is big. He points out that California represents about 12 percent of the United States population and is the ninth largest economy in the world.

This is, as Mr. Spock would say, highly illogical. It just doesn’t follow that just because you are big you will have a “dynamic and vibrant” economy. Instead, we have lots of counter examples. Great Britain was once large, wealthy, vigorous, and powerful. Not anymore.

Closer to home, we have Detroit. In 1950, Detroit’s population was 1.85 million, and it was America’s fourth largest city. Today, Detroit has a population of only 713,777. Its once-vigorous economy is not even a shadow of its former self. Its government is unable to even keep the lights on. It turns out that the lights do go off before the last person leaves.

In part two, Meyers argues the California is wealthy and this assures a prosperous future. This is, of course, the same logical fallacy as in part one. Detroit was also once one of America’s richest cities.

Meyers makes another mistake: He talks about average incomes. When it comes to incomes, averaging hides California’s real story, which is its increasing inequality and increasing poverty. California has two of America’s poorest cities. Fresno, with a poverty rate of 30.2 percent, is the eighth poorest American city over 200,000 population. San Bernardino, in the same category, and with a poverty rate of 34.6 percent, is second only to Detroit.

One of the denialists’ favorite tactics is to find a data point where California does pretty well, and then argue that the selected data point is a reason for the state to do well. Call this a selective data bias. Of course, expanding from the specific to the general is a logical fallacy. This dog is brown therefore all dogs are brown.

Typically, venture capital is the selected data. A huge percentage of the nation’s venture capital is invested in California, no doubt about it. The problem is that the nation’s venture capital is not all that much. In 2011, California received 51 percent of the nation’s $28.76 billion venture capital net investment — $14.76 billion, which represents less than one percent of California’s almost $2 trillion economy. Almost all of it went to four counties in the Bay Area.

Meyers takes selective data analysis to a new zenith. He digs through California’s jobs data to find small sectors that are generating jobs at a faster rate in California than nationwide. For example, California’s Computer and Electronic Production Sector (a sub-category of Durable Manufacturing) created jobs at a rate of 2.1 percent in 2010, compared to a national rate of 1.1 percent.

That’s all well and good, but over the past 12 months, California has lost durable manufacturing jobs. The growth that Meyers cites has only slowed California’s manufacturing jobs losses. Slowing decline is welcome, but it’s not a sign of imminent prosperity.

And he adds a nice touch discussing mining:

“The one high-wage sector in which national job gains outpaced those in California was Mining, which includes oil and natural gas production. There are several regions, such as Texas, that are blessed with generous deposits of these resources which California lacks. This advantage also shows up in Engineering Services employment…. The presence of healthy oil and natural gas resources typically generates demand for engineering consulting services related to exploration and extraction.”

That’s just wrong. California has abundant oil and natural gas resources. In fact, recent California discoveries are roughly equivalent to the proven reserves of Nigeria, the world’s 10th-largest oil producer. We’ve chosen not to extract them. We’ve also chosen to no longer exploit California’s vast mineral resources.

Chris Thornberg, Beacon Economics founder and economist, recently came up with a novel argument to deny California’s decline. He says that since recent jobs data have been revised upward, “we are in full recovery mode and not looking back.” The problem here is that the jobs data were revised from terrible to merely dismal.

Look at the data. Below are two charts summarizing changes in jobs since the pre-recession peak. The first is the United States. California is the second. Both are pretty discouraging. Four and half years after the recession, the US is still down almost 5 million jobs. This represents about a 3.5 percent net decline. California, down almost a million jobs, is even worse — down a net 6.2 percent.

Job Changes From the Peak

California has also seen slower-than-US job gains over the past year. It is worse than that, though. California has lost jobs in durable manufacturing, non-durable manufacturing, and in the other services category, labeled as Personal, Repair, & Maintenance Services in the table. By contrast, the US only saw job losses in one sector over the past year, the information and technology sector.

The very recent news is worse. In March, the most recent month for which we have data, California lost jobs while the nation gained. And the number of declining sectors has expanded to include construction, durable and non-durable manufacturing, transportation, warehousing, utilities, education/health, and leisure/hospitality.

The signs of California’s weaknesses are all around us. With about 12 percent of the US population, we have about a third of the nation’s welfare recipients. It tops the nation in teen unemployment. Domestic migration has been negative for about two decades, after a century-and-a-half of being the destination for people from all over America.

California’s weakness is the result of California’s choices. It has chosen to be anti-oil and anti-gas, and to unilaterally implement the nation’s most restrictive environmental regulations. California has elected to impose the nation’s most restrictive regulatory regime on all businesses and an onerous tax system. In short, California has chosen to be anti-opportunity and to have a weak economy. The denialists have chosen not to see California’s decline.

Flickr Photo by Steve Rhodes: Jobless not Hopeless, Ask for my resume – Chris Stewart, Union Square, San Francisco 2009

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org.

June 15, 2012

California Recovery: No, It Is Not East vs. West

Every now and then, some East Coast based publication sends a reporter out to California to see how the West Coast’s economy is doing. I think they write these things sitting at a restaurant patio overlooking the Pacific Ocean. That can be seductive, and lulled into a comfortable sense that all is well with the world, the reporter always gets it wrong.

The most recent example is this New York Times article. The second paragraph summarizes the article:

Communities all along the state’s coastline have largely bounced back from the recession, some even prospering with high-tech and export businesses growing and tourism coming back. At the same time, communities from just an hour’s drive inland and stretching all the way to the Nevada and Arizona borders struggle with stubbornly high unemployment and a persistent housing crisis. And the same pattern holds the length of the state, from Oregon to the Mexican frontier.

The next paragraph contains the mandatory quote from California’s favorite economic Pollyanna, Steve Levy:

“This is really a tale of two economies,” said Stephen Levy, the director of the Center for Continuing Study of the California Economy. “The coastal areas are either booming or at least doing well, and the areas that were devastated still have a long way to go. The places that existed just for housing are not going to come back anytime soon.”

The article is accompanied by a photo of a couple driving a red Ferrari convertible. The caption says "Driving through Newport Beach in Orange County. Communities along the coast have largely rebounded from the recession."

This is all nonsense.

There are two reasonable measures of recovery, jobs and real estate values. You can forget the real estate values measure. Values throughout California are down from pre-recession highs. They are down a lot. Only San Francisco and Marin counties, with median home prices down 27.7 percent and 32.3 percent, respectively, have seen net median home price declines of less than 40 percent. Monterey and Madera counties top the state in median home price declines, in excess of 67 percent.

So let’s use jobs. An area has recovered if it has as many jobs today as it had at the beginning of the recession, December 2008.

We monitor 37 California MSAs. Combined they represent about 96 percent of California’s population. By jobs, only one of California’s larger MSAs has recovered, and that county does not fit the story. Not only is Kings County not on the ocean, it doesn’t even border or have a naturally occurring year-round piece of water. Kings County, with 37,700 jobs, has about 900 more jobs than it had at the beginning of the recession. Still, Kings County’s unemployment rate is 17 percent. Some recovery!

Orange County, which the New York Times article cites as largely rebounded, is down 127,800 jobs from its pre-recession high. That’s an 8.5 percent decline. Los Angeles County is down 337,000 or 8.1 percent of jobs. The difference between unemployment rates, 8.0 percent in Orange County versus 12.1 percent in Los Angeles County, reflects different unemployment levels at the beginning of the recession and the high cost of living in Orange County. Most people can’t afford to be unemployed long in Orange County. You either find a job, or you leave.

Here are the Counties that have lost, on net, less than 6 percent of jobs in the recession:

County/MSA	Job gain or Loss	percent change	Unemployment Rate
Imperial	-100	-0.2%	26.7%
Kings	900	2.4%	17.0%
Merced	-2,800	-4.8%	20.0%
Monterey	-5,600	-4.3%	15.3%
San Diego	-66,400	-5.1%	9.3%
San Francisco San Mateo Marin	-33,600	-3.4%	8.0% 7.3% 6.6%
Santa Clara San Benito	-19,900	-2.1%	8.8% 18.3%
San Luis Obispo	-5,900	-5.7%	8.7%
Santa Barbara	-8,200	-4.7%	8.9%
Santa Cruz	-3,800	-4.1%	13.6%
Solano	-6,100	-4.8%	10.9%

It’s hard to find real recovery here. Three of the sub-10-percent-unemployment-rate counties (Marin, San Luis Obispo, and Santa Barbara) are home to the wealthy, those who serve them, and a very small middle class. They have not had and will never have anything like robust economies. Think of them as big Leisure Villages for the terminally fashionable.

That leaves San Diego, San Francisco, San Mateo, and Santa Clara counties as potential vigorous economies. Let’s look at these regions’ job creation last month. Unfortunately, the data are only available by MSA. San Diego County saw job growth of 1,300 jobs in February, an increase of about 0.11 percent. Santa Clara/San Benito saw job growth of about 4,100, or 0.46 percent. San Francisco/San Mateo/Marin saw growth of about 7,100 jobs, or 0.74 percent.

It looks to me like there is a small island of relative prosperity: San Francisco, San Mateo, and Santa Clara Counties, but even these counties have not fully recovered. This island is indeed on the coast, but it represents just a small fraction of the coastal county population.

The idea that there is some sort of Coastal resurgence in California is just absurd. Certainly, the 593,800 still unemployed in Los Angeles — by far the state’s most populous — are not likely to agree that “The coastal areas are either booming or at least doing well…"

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org.

California coast photo by BigStockPhoto.com.

April 16, 2012

Commanding Bureaucracies & ‘The New Normal’

Prior to the fifteenth century, China led the world in technological sophistication. Then, it went into a period of long decline. Here’s what Gregory Clark had to say about it in Farewell to Alms:

… When Marco Polo visited China in the 1290s he found that the Chinese were far ahead of the Europeans in technical prowess. Their oceangoing junks, for example, were larger and stronger than European ships. In them the Chinese sailed as far as Africa.

The Portuguese, after a century of struggle, reached Calicut, India, in the person of Vasco da Gama in 1498 with four ships of 70-300 tons and perhaps 170 men. There they found they had been preceded years before by Zheng He, whose fleet may have had as many as three hundred ships and 28,000 men. Yet by the time the Portuguese reached China in 1514, the Chinese had lost the ability to build large oceangoing ships.

Similarly Marco Polo had been impressed and surprised by the deep coalmines of China. Yet by the nineteenth century Chinese coalmines were primitive shallow affairs, which relied completely on manual power. By the eleventh century AD the Chinese measured time accurately using water clocks, yet when the Jesuits arrived in China in the 1580s they found only the most primitive methods of time measurement in use, and amazed the Chinese by showing them mechanical clocks. The decline in technological abilities in China was not caused by any catastrophic social turmoil. Indeed in the period after 1400 China continued to expand by colonizing in the south, the population grew, and there was increased commercialization.

China’s technological decline is a fascinating topic, with lessons for us today.

Right now, the United States is approximately six million jobs short of our pre-recession high, even though we’re almost three years into a recovery. We have about the same number of jobs as we had in 2000. That is worth saying again. On net, the United States has seen no job growth in over a decade, even though we’ve recently seen some slow job growth — slow relative both to past recoveries, and to potential.

Prospects for improved growth are not good. Already, the Federal Reserve has all but promised to keep I low interest rates through 2013. This is a sure sign that its 300+ economists don’t anticipate significant improvement soon.

Some observers are claiming that this is ‘the new normal,’ and we have to get used to a future of slower growth. These people are doing us a disservice. The United States still has all of the economic potential it ever had. Our job growth is unacceptably low because of our policy choices.

Bad policy is not a partisan issue. The disastrous Sarbanes-Oxley was passed during the George W. Bush administration, as was the irresponsible expansion (subsidizing prescription benefits) of the by-then-obviously-troubled Medicare program. The supposedly free-market administration instituted a tariff on steel imports, presided over an increase in government spending as a percentage of gross product, and ran persistent federal budget deficits. Finally, in a panicked reaction to the September 2008 financial crisis, it created the TARP program, a program that exacerbated our financial sector’s existing moral hazard problems.

The current administration has dramatically expanded the size and scope of government. Today, total government spending is over 35 percent of gross national product. This exceeds that of World War II. Federal debt, as a percentage of GNP, will soon surpass that of World War II, and no decline is in sight. The Dodd-Frank Act does not address any of the problems that caused the 2008 financial crisis, while imposing huge regulatory burdens on financial firms. The healthcare restructure imposes another large regulatory burden while failing to address the fundamental problem: consumption of medical services and payment for medical services have become separated.

Our bureaucracies are growing at the expense of the private sector. For evidence, look at Joel Kotkin’s piece on the relative prosperity of the Washington DC area, a region that has boomed throughout the recession. Similarly, the Sacramento Bee recently ran an article on the 200,000 plus people trying to get a job with the State government.

When government bureaucracies become very large, they attract people directly through working conditions, benefits and pay packages, job security, and power. The bureaucracy becomes the place where important decisions are made, and talented people want to make important decisions. Dealing with bureaucracy also becomes a major growth industry. Financial institutions need more compliance officers to stay out of trouble with the regulators. Pharmaceutical companies need people to navigate the approval process for new drugs. Companies across America need specialists to help them comply with employment and environmental regulations. When profits become dependent on regulatory compliance, the best and brightest become employed in facilitating compliance, or finding ways around it. Production suffers as a result.

Some would argue that government is the source of prosperity. Outside of the relatively small government necessary to ensure property rights, this is not true. As the following chart from the New York Times shows, most of government’s increased spending has gone to transfer payments.

What’s to be done? I’ve argued elsewhere that legal immigration should be increased. That can be done immediately, and it would have immediate impacts. Repeal of Sarbanes-Oxley and Dodd-Frank would also have immediate benefits. Redoing healthcare in such a way that consumption of medical services would be tied to the payment of medical services would help, too. Increasing United States carbon-based energy production would provide an immediate boost.

In the longer run, government’s share of the economy needs to decline. The least painful way would be to cap inflation-adjusted total government spending, and keep it capped while the economy grows, allowing governments share to decline to, say, 2000 levels. This would require changes to Social Security and Medicare benefits.

Which brings us back to China. It appears that a large centralized bureaucracy was a significant contributor to China’s decline. It did this through three channels: Central bureaucracies imposed inefficiencies on the economy (just as we saw in the failed USSR). Bureaucracies are also risk averse, which limited China’s upside potential. And, like other bureaucracies, it attracted the best talent.

This is not to say that the United States is 14th century China, and about to enter into an extended period of decline. But it is to say a cause of the United States sub-par economic performance is its large and growing central bureaucracy.

Photo by IvanWalsh.com: Museum of Ancient Architecture, Beijing, China

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org

April 3, 2012
Inequality and Economic Growth

There has been news and conversation about economic inequality and economic growth lately, mostly because the former is increasing steadily and the latter has been less than stellar.

Of course, there is always a tension between economic growth and equality. Economic growth implies at least some inequality. That’s because most people need incentives to create things people value. They need a reward. Creating perfect equality necessarily eliminates incentives.

The reward for innovation or effort doesn’t have to be the full value of an innovation or effort. The person who invented the wheel did not collect the present value of the innovation. Similarly, Bill Gates, rich as he is, or the late Steve Jobs, or George Mitchell, the man who helped developed “fracking” did not collect the full value of their innovations. The fact that people voluntarily agree to pay income taxes demonstrates that they don’t have to consume the full value of their effort. So, there is room for some redistribution.

Still, there has to be some reward, some incentives to work or innovate. That incentive naturally will create inequality.

Call incentive the supply side. If there is a supply side, there must be a demand side. There is, and that comes from people, but it is not what you might think.

Economic theory is based on the concept that people are happier when they consume more or better products. That turns out to not be true. People are no happier than they were 100 years ago, and we consume a lot more than our great-great grandparents.

The fact is that since the 1950s in America, and now in many parts of the world, people have been free of the worst Malthusian constraints. We have plenty to eat and on some measures we don’t really need any more. Especially with current low birth rates, not just in advanced countries but also in much of the developing world, consumption growth is unnecessary.

So, why do we need economic growth?

We need economic growth because people need more than consumption.

The great cartoonist Al Cap, the creator of Li’l Abner, understood this. Li’l Abner, his wife Daisy Mae, and the other residents of Dogpatch sometimes benefitted from the presence of a creature called a Shmoo. Shmoos bred prolifically, and could create or serve as anything humans wanted. They were perfectly happy, ecstatic in fact, to be dinner. With Schmoos around, all human consumption needs were fulfilled, with no effort on the part of the humans. It didn’t work out so well. The Shmoos were eventually killed by extermination teams to save humanity and the economy, except for two saved by Li’l Abner and returned to repopulate the Valley of the Shmoon.

We have similar real-world examples, and it doesn’t work out so well here either. It turns out that when all consumption needs are provided with little or no effort on the part of the recipient, something is lost. Drug and alcohol abuse abounds in these populations. Traditional families are destroyed. Crime is high. Violence, including domestic violence, is high. Morals are abandoned. Relationships are fluid, frequently violent, and always temporary. Health is poor, even when healthcare is provided.

It turns out that when people are provided everything they need, self-destructive behavior is the norm. It’s almost as if they have no reason to live, and it is a terrible price to pay for consumption.

It turns out that a job costs less than dependency, and that’s why we need economic growth. Jobs and opportunity provide us with some things that consumption can’t. I think those are pride, dignity, and purpose.

That doesn’t mean we should abandon the effort to provide a safety net. People are different, and few of us would be comfortable with the how the least endowed would live without a safety net. It is also true that the gods of chance can be cruel to even the most capable. Most of us would like to see some protection provided the unlucky.

A safety net reduces inequality, and is redistributive. The trick is to maintain incentives.

If we are to offer people jobs and opportunity, and we must, we need economic growth. To realize economic growth, we need to maintain incentives for the most productive and innovative. Punitive marginal tax rates are counterproductive.

How support is delivered to the recipients is also extraordinarily important. The incentive issue should be paramount. We owe it to the recipients to provide the support in a manner that preserves dignity and pride and always provides a healthy incentive to work. Far too many existing programs have effective marginal tax rates near, at, or exceeding 100 percent. This easily happens on means-tested programs, where the next dollar in income could cost the benefit plus the taxes on the new income. Here’s a quote from a report by the Employment Policies Institute:

“As an example, in states with ostensibly generous welfare benefits, Professor Shaviro shows that a single mother with two children could increase her earned income from $10,000 per year to $25,000 per year and actually find herself with 2,540 fewer dollars once she accounts for lost tax credits and benefits. Though her earned income more than doubles, she is worse off financially.”

It makes no sense to have 100 percent marginal tax rates on high-income individuals. It makes even less sense to have 100 percent effective marginal tax rates on the least advantaged.

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org

March 27, 2012
California’s Deficit: The Jerry Brown and ‘Think Long’ Debate

California has three major problems: persistent high unemployment, persistent deficits, and persistently volatile state revenues. Unfortunately, the only one of these that gets any attention is the persistent deficit. It is even more unfortunate that many of the proposals to reduce the deficits are likely to make all three of the problems worse over the long run.

Two major proposals to deal with the deficit will shape the coming debate. One is from the newly formed Think Long for California Committee; the other from the governor.

Governor Jerry Brown’s plan would increase sales taxes, and would increase the tax rate on the portion of anyone’s income that is over $250,000 (the marginal rate). It is a general rule of tax analysis that if you want there to be less of something, tax it. Indeed, this proposal would result in some wealthier people leaving California, and it would accelerate the trend of substituting internet retail purchases for local retail purchases.

It would also increase California’s tax receipt volatility. California’s tax base is dependent on the income of a relatively small group of wealthy people. It turns out that this income is more volatile than the economy. Increasing top marginal tax rates would only increase the volatility of the state’s revenue.

So, why would the governor make such a silly proposal? I’ve heard a few reasons.

• The government is starving and it needs the income now.

This is nonsense. Combined national, state, and local government spending is now over 35 percent of gross product. This is highest it has ever been, including the peak spending years of World War II.

We can disagree on the optimal size of government, but to argue that this is a time of scarce government spending is absurd.

• The wealthy have too much money. We must increase the progressivity of California’s tax code.

The governor’s proposal will do that. If implemented, the plan will give California the highest marginal tax rates in the United States. The problem is that people with high incomes often have more choices than most of us. They can move. They can reallocate earnings to other states or into less-taxed activities. They can just forego earnings if the return is too low.

Most analysts agree that California’s tax structure should be broader based. The only way to do that is to make the system less progressive, not more progressive. Increasing taxes on the wealthy may feel good when the law is implemented, but it will eventually lead to lower tax revenues, increased revenue volatility, and slower economic growth.

• There is nothing else we can do. The political situation does not allow a better fix.

It never will be easy to implement comprehensive tax reform in California. There are too many groups with too much at stake. However, it is senseless to argue that we should therefore increase the distortions in an already distorted tax code. California has been doing this for years, and it just keeps making things worse. California’s governance is a mess precisely because it is the result of hundreds of ad-hoc decisions.

California desperately needs comprehensive tax reform, “if not now, when?”

Which brings us to the proposal by the Think Long for California Committee . The Think Long committee is a subset of California’s political elite. You will recognize many of the names; for a start: Nicolas Berggruen, Eli Broad, Willie Brown, Gray Davis, Condoleeza Rice, Bob Hertzberg, Eric Schmidt, Terry Semel, Laura Tyson, and George Schultz. The proposal has three components:

Empowering Local Governments and Regions: Here’s what it says about decentralizing decision-making: “While the committee embraces the principles of de-centralization, devolution and realignment of revenues and responsibilities, we have not endeavored to propose precisely how that should be accomplished.”

That’s a bit like endorsing Mom and apple pie, isn’t it? The committee has not earned itself any honor or credibility by failing to have a proposal for one of the three major components of its plan, the first that it enunciates.

Improving Accountability: “The Citizens Council For Government Accountability – an independent, impartial and non-partisan body – would be established to develop a vision encompassing long-term goals for California’s future.”

Only, it is not a citizens group at all. It would be funded by the state, and it would have access to state agencies for support. Nine of the committee’s thirteen members would be appointed by the governor, two of whom could not be registered in either party. The Senate Rules Committee and the Speaker of the Assembly would each appoint two members, one from each major party. The committee would have four non-voting ex-officio members: the director of finance, the state treasurer, the state controller, and the attorney general.

That sounds to me a lot like just another government agency. Not exactly; this would be a super-committee with broad powers. It would soon be involved in almost every aspect of California’s government. The committee would have subpoena power, and the ability to publish on the election ballot its comments and positions on proposed ballot initiatives and referendums, as well as to place initiatives directly on the ballot.

Giving the committee the ability to place initiatives directly on the ballot is a nice touch in a document that elsewhere tries to make it more difficult for others to place initiatives on the ballot.

Restructuring the Tax Code: California’s tax code needs restructuring, no doubt about that. This proposal doesn’t get us to where we need to be, though. It reduces sales tax rates, top marginal income and business tax rates, and deductions from personal income taxes, except for education and health care, and for taxing services.

In general, these are steps in the right direction. However, exempting education and healthcare is a serious, perhaps fatal, flaw. It amounts to a huge subsidy for those industries, and places an extraordinary burden on the remaining service providers. The exempted industries are big, and exempting them means higher taxes on other service providers.

Who would actually bear the tax burden? That depends on the elasticities of supply and demand. In general, when demand is less elastic than supply (when the consumer is relatively indifferent to price changes), the consumer bears the tax burden, which is what is desired. However, for many services, it would appear that demand is not that inelastic.

Consumers can easily reduce the frequency of services such as haircuts, lawn maintenance, and the like. This would shift the burden of the tax from the consumer to the provider, that is, the hairdresser or landscape worker. In many cases, these are very low-income workers, making the tax extraordinarily regressive. California’s tax code needs to be less progressive, but this could be a huge regressive swing, one that would create extreme hardships for some of our least advantaged citizens.

Economic theory is clear that there are fewer distortions in consumption taxes than in income and capital taxes. However, these models assume that the tax burden is squarely placed on the consumer. It appears that for many services this may be impossible. Perhaps that is why we don’t observe many service taxes.

It is also the case that, in many services, taxes are avoided by the use of cash transactions. Estimates of the size of the “underground economy” vary, but most economists believe it is significant. A tax on services would likely increase its size dramatically.

The Think Long proposal is not the solution to California’s challenges. It does, however, represent far more thought than went into the governor’s proposal. It provides a service, in that it provides a starting point for a conversation that California desperately needs.

Photo by Randy Bayne; California Governor Jerry Brown

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org

January 6, 2012
California: Codes, Corruption And Consensus
We Californians like collaboration. Before we do things here, we consult all of the “stakeholders.” We have hearings, studies, reviews, conferences, charrettes, neighborhood meetings, town halls, and who knows what else. Development in some California cities has become such a maze that some people make a fine living guiding developers through the process, helping them through the minefields and identifying the rings that need kissing.

Here’s an example. This is a (partial?) list of the groups who will have a say on any proposed project in my city, Ventura:
- City agencies (Planning, Engineering, Flood Control, Traffic, Building & Safety, Utilities, Police, Fire)
- Historic Preservation Committee
- Parks and Recreation Committee
- Design Review Committee
- Planning Commission
- City Council
- School District
- Neighborhood and Community Councils
- No-Growth Citizen Groups
- Chamber of Commerce
- Ventura Citizens for Hillside Preservation
- California Department of Fish and Game
- United States Department of Fish and Wildlife
- Ventura County Local Agency Formation Committee (discretionary authority regarding annexations)
- Los Angeles Regional Water Quality Control Board (new MS4 Stormwater Permit issues)
- Ventura County Environmental Health
- California Coastal Commission (for some projects within the Coastal Zone)
- California Native American Heritage Commission and Designated Most Likely Descendant of local tribe
- United States Army Corps of Engineers
- Natural Resources Defense Council, Surfrider Foundation, Heal the Bay, other environmental groups
- And all parties who have requested to be on notice, as well as the general public and other agencies, will be informed of any California Environmental Quality Act (CEQA) document.
I didn’t pick Ventura because it is the most difficult. It’s not. I think Ventura is pretty typical for a coastal California city, actually.

The result of having all these stakeholders is that, in many California communities, particularly those in coastal and upscale locations, everyone has a veto on everything. At the beginning of a project the developer faces a huge amount of uncertainty about what the project will look like once it gets past the gauntlet and about the cost of the development process. Add to that uncertainty about who will demand what, how long the approval process will take, market conditions and the regulatory environment when the project is completed, if it is completed.

This is where the corruption connection comes in.

In economics, we teach that there are two types of corruption, centralized and decentralized. Decentralized corruption is the more pernicious of the two.

Think of a city where organized crime has a successful protection racket. This would be centralized corruption. The mob is going to collect from everyone, but it has an incentive not to collect too much. It doesn’t want to draw too much attention to itself or chase the business out of town.

By contrast, decentralized corruption consists of a bunch of independent gangs, each trying to collect all they can before the next group of thugs comes along. Each gang of thugs will demand and collect too much, and chase the business out of town.

Of course, if you want to develop a property in California no one will hold a gun to your head and demand money, and everyone is way too polite to call it extortion. Certainly, no group thinks of itself as a mob of corrupt gangsters. Instead, the members think of themselves as stakeholders, and they hold delays, lawsuits, or project denial to your head. The results are the same.

First, you have to meet everyone, and everyone wants something in return for support, or for refraining from opposition. Groups will demand “mitigation fees,” delays, studies and more studies, and changes in the project. You will meet their demands, or you will be sued, or the project will be denied.

Time spent on meetings, studies, and negotiations is expensive. The cost of the local “guide,” necessary to get through the local maze, is expensive. The “mitigation fees” are expensive. Delays are expensive. Studies are expensive. Changes in the project are expensive. Lawsuits are expensive. And risk is expensive.

Eventually, the project is no longer profitable. No wonder California’s unemployment rate is 30 percent above the United States unemployment rate.

The current climate provides California’s local governments with their best economic development opportunity: Eliminate the legal extortion by guaranteeing a project’s prompt approval if it meets existing general plans, specific plans, zoning, building codes, and adopted design criteria. Any community that did this would see immediate increased economic activity. To steal a phrase from a famous economist, it is the closest thing to a free lunch.

A city does outreach before it develops its zoning and community design plans. It only adds to the cost of development to require builders to go through the entire process again, fighting the same battles, every time a project is proposed.

The best thing about this idea is that it has been tried, and it works. The City of San Diego has seen an amazing-for-California energy since its redevelopment agency implemented such a plan several years ago. In the worst economy in 50 years, San Diego has been building and providing commercial and housing projects for all economic levels in its downtown area. It is time for the rest of California to get on with it.

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org

Photo: Two Tree Hill, Ventura California by Joseph Liao (Chowee).
December 20, 2011
Do Standardized Tests Raise Dropout Rates?

The No Child Left Behind Act became law in 2002. Among other things, it required standardized testing of students, beginning in 2003. The scores are used to evaluate the quality of the schools.

It sounds reasonable. Congress certainly thought so. It was co-authored in the Senate by Edward Kennedy (D-MA) and Judd Gregg (R-NH), while John Boehner (R-OH) and George Miller (D-CA) introduced it into the House. It passed both houses by huge bi-partisan majorities, 91-8 in the Senate and 384-45 in the House.

The Act’s passage also marked the low point in California’s High School dropout rate.

In 2002, California’s High School dropout rate had been declining for several years. After the act’s passage, the dropout rate trend experienced an unprecedented reversal. What had been a declining trend became an increasing trend, one that continues today. After bottoming out at less than 11 percent in 2002, California’s High School dropout rate is now approaching 22 percent.

The costs of dropouts are enormous, both for the students who leave school and for society. A person without a High School education is economically crippled. For all but the very exceptional few, dropping out of High School is a sentence to a lifetime of poverty and drudgery. For many dropouts, a lifetime of poverty and drudgery is the best possible outcome. Far too many will be involved in drug abuse, dysfunctional or violent relationships, teenage pregnancies, and crime.

The costs to society are large. They include losses to crime, and the direct costs of subsidies, social programs, healthcare, prisons, and law enforcement. Those costs may be exceeded by the dropout’s output deficiency, that is, the difference between what the dropout would have produced with a decent education and what he or she actually produces.

One way to improve standardized test scores is to increase the retention of tested topics by the students. An easier way is to prohibit students who would perform poorly from taking the test. Since all students have to take the test, this means converting poorly-performing students into non-students, letting them drop out.

It looks to me like California’s educational establishment has opted for the easy way.

On the chart below, the purple line shows California’s dropout rate from 1997 through 2009; you can see the percentages on the right-hand side of the chart. The other lines show the percentage — on the left side of the chart — of California’s students who passed the standardized tests for Math, Language, and Science. California’s passing percentage in each field has increased lockstep as dropouts increased.

It is worse than that, though. The percentage of students passing the standardized tests has increased by about 15 percent, on average, while the percentage of students dropping out has just about doubled. That’s an extraordinarily expensive improvement.

Did the schools follow this strategy deliberately? You can’t rule it out. People react to incentives, and the Act provides an incentive to abandon those who will likely perform poorly on the tests. Teachers will probably object to that, but we have no reason to believe that they should somehow be different that most people and ignore the incentives. Besides, we’ve already seen examples of teachers and administrators cheating on these tests.

Teachers assert that the solution to all of No Child Left Behind problems is to abandon it. The other solution, of course, is to fix the incentives. The way to do that would be to assign the schools a huge financial penalty for dropouts. Teachers and administrators would scream. They would tell us that dropouts result from problems at home and socioeconomic conditions.

No doubt, many students have terrible home conditions that put these children at a huge disadvantage, but those are exactly the children that we should be giving the most attention. A lousy home environment doesn’t explain the sudden increase in dropouts. These issues have been with us for a very long time. I took my first college economics class, The Economics of Poverty, in the 1969-1970 school year. There is nothing about poverty today that we didn’t discuss in that class, except that the returns to education have increased dramatically since then.

Failure to educate disadvantaged children guarantees that the perverse cycle of poverty and despair is perpetuated. Providing them with quality education, even with the active resistance of family, friends, culture, and the students themselves, is the only way to provide them with even the minimum hope for the upward mobility that government-provided education implicitly promises.

Abandoning our least advantaged children is unconscionable. If we are to have an egalitarian and merit-based society, we must reduce the dropout rate. The way to ensure that no one is abandoned is to penalize the school for dropouts. It sounds harsh, but we owe it to the students, and we owe it to ourselves.

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org

Flickr Photo by kerryj.com: “On national standardised testing, from a brilliant educator in Western Australia – a student’s view of national summative assessments”.

November 16, 2011
First Step for California: Admit There’s a Problem
The October 29, 2009 issue of Time Magazine had an article titled “Why California is America’s Future.” I sure hope not. California is fast becoming a post-industrial hell for almost everyone except the gentry class, their best servants, and the public sector.

We only need a few numbers to demonstrate that California is clearly on the wrong track:
- California’s unemployment rate is over 12 percent, about a third higher than the United States.
- Only eight of California’s 58 counties have unemployment rates in single digits.
- California has lost jobs in four of the past six months for which we have data, while the United States has gained or had no change in jobs in each month over that period.
- California’s poverty rate is 16.1 percent compared to the United States 15.1 percent. The rate goes way up when adjusted for the cost of living. For example, the respected Public Policy Institute of California estimated that Los Angeles County’s 2007 poverty rate increased 11 percentage points from 15 to 26 percent, when adjusted for cost of living.
- Two California cities, Fresno and San Bernardino, are among the ten poorest American cities with populations over 200,000. In fact, San Bernardino’s 34.6 poverty rate is the second highest of these cities, exceeded only by Detroit.
- Unemployment among college educated is 34 percent higher in California than in the United States, while Los Angeles’s college educated unemployment rate is almost a whopping 80 percent above the United States’ rate.
- According the California Department of Education, California’s public colleges and universities graduate over 150,000 students a year, while California’s Economic Development Department is forecasting less than 50,000 openings a year for jobs that require a college degree.
Of course, that’s not the future that Time was selling. Time’s future was a “dream state,” a magical place where enlightened pioneers, guided by their superior vision and funded by venture capital, would lead the world in innovation and environmental bliss. California firms, like Solyndra, would lead the competition to a competitive new green economy. No kidding, they named Solyndra:

"It’s (California) building massive power plants for utilities, as well as roof panels for big-box stores, complete subdivisions and individual homes. Prices are plummeting, and competition is fierce, most of it from California firms like BrightSource, Solar City, eSolar, Nanosolar and Solyndra."

Along the way to this brave new world, there would be a new, “green” gold rush “beckoning dreamers who want to cook Korean tacos or convert fuel tanks into hot tubs.”

That vision turned out to be about as real as Disneyland – but not as profitable.

Time wasn’t alone. Brett Arends had a similar piece, The Truth about California, in November 2010, and the ever-optimistic duo of Bill Lockyer and Stephen Levy had a December 2010 piece, California isn’t Broken.

Visitors can be forgiven for seeing California as a bit of paradise on earth. It is. I am a native myself who could not wait to return from my job at the Federal Reserve in Washington, DC. I remember going to Santa Barbara in October for my UCSB job interview. Santa Barbara was magical to me, after enduring weeks of dreary and increasingly cold East Coast weather. Santa Barbara was warm and sunny, and people were wearing the minimum legal requirements, and State Street was alive and vibrant with a happy energy I hadn’t seen since I’d left California for my East Coast job over a year before.

I wanted that job.

You can still have that experience in certain spots in California. There’s no doubt, California has abundant charms. It can seduce almost anyone.

But there is a lot of California that visitors don’t see. They don’t see the many communities in California’s central valley where unemployment rates of over 15 percent are typical, where people live in substandard housing and face the prospect of a lifetime in an ignored underclass.

Well, they are not exactly ignored. They receive food stamps and other subsidies, but they are denied opportunity, social mobility, or the confidence and pride that come with self-sufficiency.

You don’t have to leave Santa Monica or Santa Barbara to see poverty without opportunity though. Just blocks from Santa Barbara’s State Street or Santa Monica’s Third Street Promenade, over-crowded units , packed sometimes by several families, are the norm, because Coastal California’s housing prices are not related to the local economy. Statewide, 28 percent of California’s children live in crowded housing. This is the highest rate in the nation, tied only with Hawaii.

When you live here, you can’t avoid the signs of California’s decline. Beaches I walked with High School dates are no longer safe at night. Water lines in Los Angeles burst with alarming frequency. Our roads are approaching gridlock and are littered with potholes. Electrical cutbacks are common in hot weather. Water is increasingly scarce, except in very rainy years. Our primary schools are clearly in decline. Even California’s higher education system, once the envy of the world, has passed its prime. Places like the University of Texas or University of North Carolina are now real competitors.

It wasn’t always this way, and it doesn’t have to be in the future. When I started my career, California was a place of opportunity. One could have a career, own a home, and raise a family.

Not any more – not unless you have a trust fund or a secure pensioned public employee job.

That’s why California’s middle class is leaving, looking for opportunity and affordable housing. The evidence is in the migration data. Domestic migration has been negative for over a decade. Perhaps even more telling, only 23 percent of U.S. illegal immigrants are coming to California today, down from about 42 percent in 1990. Even the lowest skilled newcomers know there’s shrinking opportunity here.

California has a problem, and it’s high time the political class accepted the fact.

Two steps need to be taken before any problem can be solved. You need to recognize you have a problem. Then you need to identify the problem. Unfortunately, it appears that among Sacramento’s leadership, only Gavin Newsom even recognizes that California has a problem. Governor Brown gives lip service to jobs, but like Schwarzenegger before him, identifies the failed command and control policies of the green movement as the source of the new jobs. Solyndra has become the poster child for this fantastical policy failure.

California’s economic future is pretty grim, until Sacramento takes off the blinders and admits it has a problem. Until then, things are likely to get much worse before they get better.

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org

Photo illustration by krazydad/jbum.
September 27, 2011
Why the Eurozone Will Come Apart
Europe has been in the news a lot lately. One day it has a plan to, temporarily at least, deal with the debt problems of delinquent members, and markets climb. The next day there is a glitch and markets fall. What is going on here? Why are markets so spooky?

We’re witnessing what are almost surely the dying gasps of the European Union (EU) as we know it. By that, I mean the number of countries in the Euro’s common currency zone will decline. The markets are spooked, because how it happens will have huge economic consequences.

Most economists — I’ve seen references that it is as many as 70 percent — thought that Europe was making a mistake when it became a common currency zone in 1999. Milton Friedman said that it would not make it past the first large recession. He was correct.

There are two fundamental ways that economists look at currency unions. One question is: What is the likelihood that countries will stay in a currency zone? This is the traditional theory of optimal currency zones. The other asks: What are the challenges to individual countries in a currency zone? This is what economist Greg Mankiw calls the fundamental trilemma of International finance.

The traditional theory of optimal currency zones holds that, for a currency zone to be successful, the countries need to be similar in fundamental ways. Inflation rates need to be similar. Openness to trade needs to be similar. The countries should be diversified in what they produce. Policy should be integrated, as should the countries’ financial sectors. Capital and labor should be mobile between countries.

In Europe, the countries are just too diverse to create a long-lasting currency zone. Languages and cultures are very different across European countries.

A large currency zone works better in the United States. There are fewer differences between, say, New York and California than between, say, Greece and Germany.

Still, even in the United States, states would choose different monetary policies if they could. For instance, California today would prefer a more expansionary policy than would Texas. This is because the Texas economy is doing far better than is California’s, and Texas has fewer fiscal challenges than California faces. An expansionary monetary policy would presumably stimulate California’s economy, while simultaneously allowing the state to inflate away part of its debt.

This reflects the trilemma. Here’s an abbreviation of how Mankiw described the trilemma in a 2010 New York Times op-ed:
“What is the trilemma in international finance? It stems from the fact that, in most nations, economic policy makers would like to achieve these three goals:
Make the country’s economy open to international flows of capital.
Use monetary policy as a tool to help stabilize the economy.
Maintain stability in the currency exchange rate.
But here’s the rub: You can’t get all three. If you pick two of these goals, the inexorable logic of economics forces you to forgo the third.”

As Mankiw goes on to say, the United States has chosen the first two options, while China has chosen the second and third, and Europe has chosen the first and third. Right now, Greece and many of the other peripheral countries would like the ability to use the second option.

The troubled European countries not only have no monetary policy choices, their fiscal options are limited, too. In trying to force countries to meet the characteristics of an optimal currency zone, the EU puts severe limits on fiscal policy choices. This is why at least one country, Greece, has simply lied about its debt.

In the end, the Greeks and the citizens of other peripheral countries will demand that their governments use all the economic tools available to a sovereign country. The governments will have to comply. The euro zone will shrink.

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org

Photo: Photo: European Union Flags by futureatlas.com
September 18, 2011
Commercial Real Estate: Shrinking to Fit

We are going to need less commercial real estate in the future, at least on a per-unit-of-population basis. Advances in communications technology are causing profound and sometimes unanticipated changes in our lives.

Retail Markets
The coming change is most obvious in retail markets. Americans are increasingly shopping online. However, we’ve really just started to scratch the surface. According to the U.S. Census Bureau’s 2009 E-Stats report issued in May, 2011, E-commerce only accounted for 3.99 percent of U.S. retail sales in 2009.

I was surprised at how small that number was. Certainly it is higher now, and the 2009 number was almost double 2004’s 2.13 percent, but there is huge room for increased internet retail sales. This is a growth business with a capital G.

Originally, I believed that traditional brick-and-mortar retailers would have the advantages of customer service and product knowledge, and internet purchasers would be product-savvy shoppers looking for products that they already knew about. That has turned out not be the case at all.

It is true that the initial internet retail sales successes have been in products where technical knowledge is not critical, and tastes are well established; products such as music, movies, and books. However, online retailers have made impressive gains in providing customer assistance to shoppers looking for more technical products.

Ratings of products and retailers were an initial step, along with detailed technical data. More recently, internet retailers have added chat windows, some with pictures of the salesperson. It won’t be long until voice or live video are offered, if it isn’t already.

It is now the case that you are more likely to find more informed assistance on the internet than you will from a brick-and-mortar retailer. This is not to say you can’t find good assistance at a traditional retailer. But your online experience is likely to be better than what you will receive if you walk into a store and deal with the first person you bump into.

As internet sales increase, expect to see fewer traditional retailers and less demand for retail space. Already, shopping centers anchored by a music store, a video store, or a book store have felt the impacts. This is only the beginning.

Commercial rents will be softer and vacancies higher in large regional centers and in neighborhood strip malls. This will tend to drive retailers to ever larger centers with more traffic. Smaller centers will likely slowly deteriorate and die. In the end, we’ll have fewer retail centers, but the average center will be larger than it is today.

Office Markets
While the number of workers telecommuting is still small, it is growing; someday, it will be very large. Initially, the growth in telecommuting was driven by workers’ desires to physically commute on fewer days. Today, the initiative is changing to employers.

Companies that adapted to telecommuting employees began to learn how to supervise these workers. Some companies have gone further. My son works for a company that has closed many physical offices, but kept most employees. Everyone was told to telecommute.

For companies that have made the strategic decision to reduce office space, the advantages must be large. Certainly rent goes down, but other expenses go down too. Heating and cooling costs go away. The company no longer needs to support a local network, with the local network’s support costs.

I haven’t seen research on telecommuters’ productivity, but it is easy to imagine it increases. Think “happy employees are productive employees.” It is also easy to imagine that productivity decreases. Think “unsupervised employees are unproductive employees.” Clearly, telecommuter productivity is the key to profitably running an office-free operation. As someone once said “any job performed on a computer can be performed anywhere.”

The lower demand will result in lower office space rental prices and higher vacancies. Again, this should lead to office-dependent operations migrating to the better addresses. In the end, the less-desirable buildings will be empty.

Industrial Markets
We’ve seen the huge increase in overseas manufacturing, and we’ve seen the steady decline of U.S. manufacturing jobs. That is just the first stage of a profound transformation in the way things are produced. As the song goes., “You ain’t seen nothing yet.”

Manufacturing’s future is nicely exemplified by three-dimensional printing. Today, you can Google “three dimensional printing” to find links to videos of three-dimensional printers producing amazingly complicated products, or find companies that have three-dimensional printers. Or you can use a three-dimensional printer to produce something.

I expect the growth of three-dimensional printers to be something like what we saw with copy machines. The first copy machine I used was in a drug store, and it was coin operated. Then, the banks made them available to customers. Today, we all have at least one in our home and one at the office.

The day will come when three-dimensional printers will be ubiquitous. You will download instructions for products from some company like Amazon. Then you will produce your good, without the need for an industrial building or a brick and mortar retailer. Producers of products that can’t be printed will print parts, reducing the demand for other producers, inventories, and shipping.

Any Growth Areas?
Buildings associated with providing healthcare may be the major exception to declining commercial real estate demand. The aging population, new technology, and long-term wealth trends are likely to continue to drive growth in the economy’s only sector that has grown consistently throughout the recession. At least so far, technological advances in medical care have increased demand for space instead of decreasing it.

Specialized R&D space may also buck the trend. Many of these facilities can be specialized, however, to the point of being profitably used by only one company. That implies that these buildings are risky investments.

Policy Implications
The decline in commercial real estate demand will pose serious challenges to governments. We’re already seeing states and local governments struggle with loss in retail taxes from internet sales . Declining revenues are just the beginning, though. Expenses will increase.

Empty buildings generate crime. In the case of retail centers, the crime will be very public. Nearby residential property values could decrease, with additional lost revenue to governments. Residents will not stand idly by. They will demand effective action — action that could be very expensive.

To minimize the fiscal damage, local governments will need to be nimble, a characteristic that few governments possess. They will need to be willing to change zoning codes to adapt to the decline in commercial real estate. They need to allow owners of existing space to redevelop or change their product mix. They may need special tax districts to deal with the blight created by vacant properties.

Growing population and an eventual real recovery will eventually fix the residential real estate problem. Commercial real estate’s challenges will not be so easily addressed. The impacts are not only on owners, developers, and contractors . All of us will be affected. The time to plan for those changes is now.

Bill Watkins is a professor at California Lutheran University and runs the Center for Economic Research and Forecasting, which can be found at clucerf.org

Photo by Mark Lyon — Full Floor For Rent.

August 10, 2011