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WEST OF EDEN
California's Economic Fall
by Steven Hayward
From the Summer 1993 issue of Policy Review
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     Economic catastrophe has struck California with the violence
of an earthquake. For decades, California has been the most
socially and economically dynamic state in the nation and one of
the entrepreneurial capitals of the world. It truly has been
America's Golden State -- the El Dorado with its beaches and
mountains, its sunshine, its majestic forests, its fountain of
eternal economic opportunity. In the 1980s, California
outperformed even the booming national economy.
     The gold rush is over. California recently has been buffeted
by natural and social disasters -- drought, fires, flooding,
earthquakes, riots -- and by a recession that has hit California
harder than any other state in the nation. With 12 percent of
America's population, California has accounted for one-third of
the total national job loss. 
     California often has led the nation out of recessions. Now,
the collapse of the country's most enterprising economy is
holding back the national recovery. All forecasts call for
California to underperform the national economy in the 1990s,
with employment and income declining through 1995. California's
crisis has revealed a state government with out-of-control
spending and burdensome bureaucracy, with even worse news to come
in the next few years if changes are not made. Meanwhile, despite
a steady flow of foreign immigrants, California is experiencing
net domestic outmigration (more people leaving for other states
than arriving from them) for one of the few times in its history.
In 1988, 100,000 people moved to California from other states;
this year, nearly 100,000 may leave.

Economic Fault Lines

     Fault lines in the California economy were cracking open
beneath the surface of the 1980s boom. Government regulation
increased rapidly, taxes crept back up to their ruinous levels
before the Proposition 13 property-tax revolt of 1978, and rapid
spending growth left the state budget vulnerable in a recession.
Although the California economy was booming, per-capita income
growth was actually lagging behind the national rate.
     As early as 1983, then-chairman of Hughes Aircraft, Allen
Puckett, criticized California for being anti-growth and declared
that Hughes no longer would invest in new plants in California.
Hughes kept its word throughout the rest of the 1980s, but with a
growing economy, a high rate of new business formation, and
vigorous job growth, it didn't seem to matter if or why
businesses moved or expanded out of state. This attitude of
invincibility persisted through the beginning of the national
recession in the second half of 1990. When Forbes published a
cover story about California's deteriorating business climate in
October 1990 -- "Is the Golden State Losing It?" -- the article
was greeted with a flurry of dismissive criticism by the local
media.
     State government joined in the miscalculation. In fall 1990,
the Commission on State Finance, which makes independent economic
and employment projections, predicted that California would
experience a loss of 30,000 to 40,000 jobs in the coming year. By
fall 1991, the number of jobs lost already had passed 300,000,
and had not yet reached the half-way mark. The projected state
budget "shortfall" for the fiscal year beginning on July 1, 1991,
which was thought to be $7 billion in January, quickly grew to
$10 billion in February, $12 billion in late March, and finally
to more than $14 billion the following May. Budgets for 1992-1993
and the coming fiscal year are each more than $10 billion in the
hole.
     The causes of California's collapse, and whether some of
them could have been avoided, are debatable. Almost everyone
agrees that California's economic "bio-rhythms," so to speak,
were all out of synch at once: a general recession, a cyclical
real estate slump, a decline in foreign, especially Japanese,
investment, and steep defense cuts.
     California enjoyed a bigger real estate and construction
boom than the rest of the country in the 1980s, and it has
suffered from a bigger bust, as overbuilding in commercial real
estate led to the savings and loan crisis and credit crunch.
Although California's population continues to grow by more than
500,000 people a year, housing construction has fallen from
237,000 units in 1989 to just under 100,000 in 1991. In Southern
California, which has been hit hardest by the slump and where
most of the new population growth is, only one housing unit has
been built for every 25 new residents in the past two years.
Non-residential construction also has fallen by more than half
since 1988. Construction-industry employment has fallen by nearly
30 percent since 1990.

Japan's Setting Sun

     Less widely noticed has been the precipitous decline in
Japanese investment in California. This decline probably owed as
much to the collapse of the Tokyo real estate and stock markets
as to the decline in investment opportunities in California.
Japanese investors poured $7.4 billion into 68 California
companies in 1990; in 1992, the Japanese invested only $620
million in 27 ventures. Japanese investment in California real
estate has suffered a similar steep decline, from more than $5
billion in 1988 to less than $300 million in 1992.
     Perhaps the most symbolic example of the decline was
Japanese developer Minoru Isutani, who paid $850 million in 1990
to buy the famed Pebble Beach golf resort -- only to sell it for
$500 million last year. Meanwhile, Japan's California banks hold
$60 billion in loans, a third of which are in commercial real
estate whose value has fallen sharply over the last two years,
leading to write-downs of loan values. Indeed, Japanese real
estate investors in California suffered from many of the same
speculative excesses they suffered in Japan. In 1992 Japan's
California banks lost money for the first time since becoming a
major presence in the state's banking industry. (California's
banking industry in general has done as poorly as the rest of the
economy, with 31 percent of the state's banks, including two of
the 10 largest, reporting losses in 1992, up from 25 percent
reporting losses in 1991.)

Military Meltdown

     A third major factor in the crumbling California economy is
defense cuts. California always has been a key state for the
defense industry, accounting for more than 20 percent of the
nation's defense-procurement spending. The end of the Cold War
has meant anything but a "peace dividend" for California,
however, where more than 120,000 defense and defense-related jobs
have been eliminated in the past two years. Another 50,000
defense jobs may go by the end of 1993, and California will
probably lose another 50,000 to 60,000 military jobs through base
closures during the rest of the decade. The decline in defense
spending is a prime reason why California, which received $1.22
in federal spending for every $1 in federal taxes paid 10 years
ago, only receives about 90 cents for every $1 in federal taxes
paid today.
     What makes this round of defense cuts more significant is
not the seeming finality of the post-Cold War defense downsizing,
but the concurrent decline of the related civilian aerospace and
high-technology sectors, where defense workers used to be
absorbed in years past. Losing massive numbers of jobs in
competitive sectors like civilian aerospace, electronics, and
other manufacturing should raise a red flag that something else
is at work -- a deteriorating business climate. Peter Ueberroth,
appointed chairman of a special Council on California
Competitiveness by Governor Pete Wilson in 1991, concluded that
"California's economic wounds are mostly self-inflicted."
Numerous business leaders agree. Jerry Jasinowski, president of
the National Association of Manufacturers, recently declared that
California "clearly has the most anti-business climate in the
country."
     Many liberal policymakers in California still deny that
there is anything seriously wrong with the state's business
climate. But the evidence seems overwhelming: a stampede of
companies has moved or expanded out of the state. According to a
survey conducted by several public utilities, 668 manufacturing
facilities either have moved or expanded outside of California
since 1987, costing the state 92,000 manufacturing jobs; no one
knows how many other jobs these plants would have supported. The
survey found that 87 percent of these companies cited
California's business climate as a major factor in their decision
to relocate. A California Business Roundtable survey of 1,325
companies found that 44 percent intend to relocate or expand
outside of California. The trend has become so pronounced that a
3M plant in Stockton recently made the news when it announced it
was not leaving the state.
     The resulting loss of revenue to the state is staggering.
And it is only a fraction of a multi-billion-dollar exodus to
greener state pastures. Hughes Aircraft chairman Michael
Armstrong estimates that Hughes' move to Arizona will cost state
and local government more than $600 million in tax revenue every
year.

Hot Tub to Cold Shower

     Californians would not have to worry too much about
businesses leaving the state if new companies relocated there to
take their place. But in 1990, California suffered the biggest
decrease in the number of new business startups nationwide, and
business failures soared. As recently as 1988, California ranked
third in the nation in the number of new manufacturing plants. By
1990, California did not even rank in the top 10 states.
     The sorry business climate results partly from the high
costs of doing business -- costs that often are driven up by
government regulation. True, some costs are functions of high
demand in a dynamic marketplace; utility rates, for instance, are
as much as 50 percent higher in California than in neighboring
states.
     However, the state's high housing costs also make it
difficult for employers to attract skilled workers. California's
median home price is $211,000; the national median price is
$103,000, while the median home prices of neighboring western
states are below the national average. This price disparity is a
recent development. In 1974, California's median home price was
only slightly above the national median.
     There is abundant evidence that government regulation, more
than market demand, is the chief cause of soaring housing costs
California has experienced. In addition to development-impact
fees that can add up to more than $40,000 per house in many parts
of California, planning delays and permit conditions can nearly
double the cost of building a new home.

Stressed Out

     The most expensive example of government-imposed costs is
workers' compensation, which is driving small and medium-sized
businesses out of California. Between 1981 and 1991, the cost of
California's workers' compensation program rose more than 200
percent. Over the same period, the workforce grew only 25
percent, and the rate of disabling injuries per 1,000 workers
declined. A clue to the problem is revealed in the following
fact: while California's workers-comp system ranks among the top
five in the nation for cost, California ranks 44th in benefits
paid to injured workers. A large number of middlemen obviously
are feeding at the trough as well.
     A potent political combination of lawyers, doctors, clinics,
and insurers prevailed upon the legislature over the last decade
to enact an expansive definition of compensable disability. Under
this enlarged definition, an able-bodied person can collect on a
"cumulative stress" claim, even if the job only contributed to 10
percent of the "stress." Virtually anyone who commutes in
California's legendary freeway traffic can qualify under this
absurd standard. Not surprisingly, stress claims have increased
700 percent in the last decade. Fraud is rampant, as a "60
Minutes" segment exposed last year. Yet, with such elastic
thresholds of "injury" through "stress," it is hard to tell fraud
from legitimate stress. A favorite tactic of laid-off or
terminated workers is to file a stress claim immediately. Many
are successful. When the Good Companies, a furniture manufacturer
in the Los Angeles area since 1956, moved to Mexico chiefly to
escape the prohibitive cost of local air quality regulations,
they laid off 600 workers. When the company announced the
layoffs, a workers-compensation attorney parked vans in front of
the plant and ferried workers to the attorney's office. Of the
600 workers, 530 filed workers-comp claims against the company.
     The result of such a system is skyrocketing insurance
premiums that render California companies uncompetitive with
out-of-state producers. Total workers-comp insurance costs now
top $10 billion a year in California -- not much less than the
state takes in through the corporate-income tax.
McDonnell-Douglas reports that it pays $785,000 in workers'
compensation premiums for every MD-80 airplane it builds in
California. Seattle-based Boeing pays only $235,000 per similar
aircraft. Not surprisingly, many companies that have moved from
California have been able to recoup their moving costs in the
first year from savings in workers comp costs alone.
McDonnell-Douglas is now among the exiles: having already
announced that it would build components for its C-17 transport
plane in Missouri, McDonnell-Douglas recently announced that two
major new programs, the AH-64 helicopter and its next generation
MD-12 jumbo passenger jet, also will be made outside of
California.

L.A. Law

     McDonnell-Douglas and other manufacturers say that other
government regulations, especially environmental regulations, are
as damaging to business as workers' compensation. California's
environmental standards are tougher than the federal
government's. Perhaps the most serious obstacle to economic
activity comes from the complexity, delay, and uncertainty of the
environmental review and permit process. In Los Angeles County,
for example, businesses must get environmental permits from as
many as 27 local agencies and up to 32 state agencies. Federal
agencies also get in on the act, bringing the possible total
permit gauntlet to over 70 agencies.
     Environmentalists frequently use legal challenges under CEQA
to prolong the lengthy review process for up to a decade. For
instance, it took one company 10 years to move from initial
permit application to groundbreaking for a $140 million recycling
and waste reduction center. During that time, the project was hit
with 20 CEQA lawsuits from citizens, all but one of which was
unsuccessful. Companies that operate in several states -- retail
distribution warehouses, for example -- routinely report that
identical projects are up and running in other states before the
review process is even half finished in California. As one
exasperated businessman told a state Senate committee hearing
last year, "I would rather have a `no' in two months than a `yes'
in two years."
     The worst example of regulatory overkill and perverse
bureaucratic incentives is the South Coast Air Quality Management
District (SCAQMD). The South Coast AQMD is charged with battling
smog in the greater Los Angeles area. While L.A.'s
worst-in-the-nation smog should be attacked aggressively, the
SCAQMD and its regulatory strategy are a textbook model of an
unaccountable anti-business bureaucracy. The district has its own
governing board that is constituted through a fragmented and
Byzantine process. Unlike the federal EPA, which must get an
appropriation from Congress and submit to congressional
oversight, the SCAQMD does not have to answer to the state
legislature. It sets its own budget and raises its own revenue
through permit fees and fines levied directly on businesses in
the region -- up to $25,000 a day. An older school of
jurisprudence probably would have found the SCAQMD's autonomy to
be an unconstitutional violation of the separation of powers.
     Not surprisingly, the SCAQMD emphasizes regulations that
generate revenue through permit fees on stationary sources of
smog -- which means businesses -- even though two-thirds of the
smog in L.A. is generated by cars and trucks. SCAQMD did its best
to conceal the extent to which its overall plan would become an
albatross around the neck of the region's economy. The district
originally estimated that its regulations would cost about $3
billion a year. However, two independent estimates, one by the
National Economic Research Associates (NERA) and another by
Resources for the Future (RFF), placed the cost at $10 to $12
billion a year, or nearly $2,700 per household in the region.
     NERA researchers noticed that the district's estimate left
out any cost figures for more than half the regulations contained
in its 20-year plan. When the district added up its estimated
costs, it simply added a "zero" to the bottom line whenever it
came upon one of these uncalculated measures. When pressed in a
public forum about this peculiar methodology, the chairman of the
District's board said they didn't want to use "arbitrary
figures." The NERA and RFF estimates reasonably suppose, however,
that the uncosted regulations would cost something rather than
nothing.
     Under pressure, the SCAQMD has softened somewhat its
anti-business attitude and has moved to adopt a market-based
tradable permit system that has long been advocated by
market-oriented economists and environmentalists. Meanwhile,
efforts to streamline the environmental review and permit process
are reaching a fever pitch. The secretary of the California
Environmental Protection Agency, James Strock, describes the
environmental review process as "convoluted, overly complex, and
unnecessarily burdensome." Strock has made streamlining a major
priority, but legislative action is required to cut away the
thicket of red tape.

Leading the Tax Pack

     All of this economic misery and regulatory excess would seem
to provide conservatives with golden opportunities to advance a
conservative agenda; however, conservatives have had a hard time
finding their voice. For the past 10 years, California's
Republican governors have taken the blame rightfully belonging to
the liberal legislature. Along with the sorry fortune of
President George Bush, Republicans received the lion's share of
the voters' wrath last November. California provided Clinton with
one-third of his national vote margin over Bush. In addition,
Republicans actually lost a seat in the State Assembly, where
they had been expected to pick up several seats on account of a
favorable reapportionment following the last census.
     Along with liberal dominance in the legislature has come
staggering growth in California's government. Between 1958 and
1991, state per-capita spending (adjusted in real 1991 dollars)
increased from $629 to $1,716. While real state spending per
capita tripled, real per-capita income less than doubled. Hence,
state government's share of personal income has risen from about
4.8 percent in 1962 to over 8 percent today. California is one of
nation's 10 highest-taxed states on a per-capita basis.
     The booming economy of the mid-1980s generated huge revenues
that allowed the state budget growth at times to hit double-digit
rates. Even with this rapid revenue growth, however, the state
budget was still running a cash deficit every year. Each year the
state budget would include a $1 billion or more "contingency
reserve," but every year except one the reserve would finish the
year several hundred million dollars below the budgeted figure.
As long as the budget was technically in surplus, no one
complained.
     The onset of the recession in 1990 quickly exposed the
unsound basis of state spending, and turned the small deficits
into a huge gap. Revenues have been billions of dollars below
forecasts, but the growth of spending continues unabated,
actually rising in 1991 and 1992. Incredibly, even though the
state's private sector has lost over 800,000 jobs, state
government employment has risen by more than 5,000 employees
during the past three years.

Coast Accounting

     The state budget is driven largely by earmarking and
automatic spending increases for entitlement programs. The
caseload for entitlement programs such as welfare and Medical
(California's version of the federal Medicaid program) is growing
at double-digit rates, while the number of taxpayers is not. The
ratio of taxpayers to subsidy recipients is falling rapidly, so
much so that even a vigorous economic recovery is not likely to
generate enough revenue growth to balance the budget in the next
few years. Governor Wilson has called this "the taxpayer
squeeze." By the year 2000, the Department of Finance estimates,
the budget could still be $15 billion in the red. "There is
simply no revenue system in the world that can pay for this kind
of spending," a Department of Finance official told Policy
Review.
     Governor Wilson hurt himself badly in 1991 by agreeing to a
$7 billion income and sales tax increase -- the largest in state
history -- to help close the $14 billion budget gap. As
supply-siders predicted, the tax increases failed to generate the
revenue projected. Governor Wilson has since said that the tax
increase was a mistake and has tried to hold the line on taxes in
the face of successive combined budget deficits of more than $20
billion. Last year, the state had to resort to issuing IOUs to
pay its bills, as the legislature bickered for more than two
months at the beginning of the fiscal year before finally passing
a budget. Governor Wilson now is proposing to roll back a part of
the state's sales tax, reduce entitlement spending, and privatize
some parts of state government.
     Fixing California requires a massive overhaul of its budget
process and regulatory laws. Fundamental budget reform should
include the elimination of earmarking and automatic increases
based on social program caseloads. Earmarking and "workload"
budgeting remove spending control from the domain of legislative
deliberation and accountability. Several studies have shown that
state budgets grow more slowly in states without such spending
discretion.
     In order to reform the budget process and slow down overall
spending growth, such spending programs as entitlements and
corrections must be reduced first. State and local governments
spend over $3 billion a year on entitlement programs for illegal
immigrants; California's welfare grants are among the highest in
the nation. Spending for corrections has soared by nearly 600
percent since 1978. California's incarceration costs rank among
the highest in the country. Privatizing some medium-security
prisons in addition to some other cost-cutting measures could
make a huge dent in budget spending.
     Second, taxes need to be lowered and redistributed. One of
the unintended consequences of Proposition 13 was the
centralization of revenue at the state government level. Local
governments in California have been gradually transformed into
administrative units of state government because the state
tightly controls the money flowing back to local government. Not
only should taxes be lowered, but a portion of the tax base
should be shifted directly to local government control.
     Third, some of the functions of state government need to be
downsized and privatized. A few of the nearly 400 state boards
and commissions, including such august bodies as the Pet Bird
Advisory Committee, have been abolished, and the Wilson
administration has dozens more on the chopping block. But this
isn't where the real money and trouble is. There is still a lot
of redundancy and unnecessary bureaucracy that can be eliminated.
Does California need, for instance, both a free-standing
Integrated Waste Management Board, and a Division of Recycling in
the Resources Agency, who are tripping over each other while
doing the same things?
     Fourth, environmental and other regulations must be
reformed. California needs to reevaluate whether its own
environmental standards, which usually are tougher than federal
standards, have been set unrealistically or unscientifically.
Conservatives need to press not only for a streamlined review
process, but also for the adoption of market-based or
incentive-based environmental policies, which are a less costly
and more effective alternative to the bureaucratic
"command-and-control" regulation now in place. The good news is
that some environmentalists in the state are sympathetic to these
ideas. Conservatives have a unique opportunity to form coalitions
with moderate environmentalists against the bureaucrats and the
radical environmentalists.
     Much of this agenda probably cannot be accomplished without
a conservative majority in the state legislature. But
conservatives can hope to gain strength in California with the
right themes and a strong voice. The split between conservatives
and moderates in the California GOP has been overblown in the
media. Although disagreements and enmity exist, the disastrous
result of the last election has had a chastening effect on both
camps -- with both reaching for the common ground that does
exist, especially on economic issues.
     Term limits soon will take effect, throwing the legislature
wide open for a complete change. A bold school-choice initiative
is on the ballot for a special election in November, around which
conservatives can emphasize the themes of empowerment and
opportunity, especially for the state's large minority
population. School choice would also break the power of the
teachers' union and reform inefficient education spending.
     Above all, California conservatives need to regain the
dynamic themes of opportunity and growth that have served them
well in California and elsewhere in the past. The huge budget
deficits should be regarded as an opportunity for conservatives
to press for the kind of changes in government that thus far have
eluded them both in California and across the nation. There
simply is no other way to avoid the economic equivalent of a
tectonic shift along the San Andreas.

STEVEN HAYWARD is research and editorial director for the Pacific
Research Institute in San Francisco, and a contributing editor to
Reason magazine.

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