There are no surprises in our California forecast.  There aren’t any changes either.  We expect California to continue plugging along as it has for several years now.  The growth on average will be slow, but the Bay Area will do better.

We don’t see much upside potential.  That is, we would be very surprised if California’s economy did a lot better than the forecast.

We see plenty of downside potential.  New regulations and taxes will have a negative impact, but we would not expect to see an immediate or dramatic drop.  Instead, we’d expect to see California’s economy slowly lose vigor.

A national or global financial—it’s possible, leverage is high and banks are stressed worldwide, particularly in Europe—crisis would have more direct impact.  The immediate impact would be a large fiscal deficit at the state level.  The State’s response would likely be as always.  Taxes would go up.  Transfers to local governments would go down.  Debt would go up.

California’s financial situation has improved during Brown’s two terms, but California has not made the fundamental changes necessary to increase the budget’s resiliency.

Making California’s budget less susceptible to business cycles would require a major tax restructuring, reducing the reliance on a wealthy few while broadening the tax base.  It would also require that the State’s pension obligations be brought under control.

Is Sacramento likely to make the changes necessary to strengthen California’s budget?  Probably not, but now seems like an excellent time to do so.

A one-party state provides opportunity.  While the required changes would help most Californian’s, some groups would be hurt.  Those groups are part of the ruling party’s coalition, government employees and those who despise the existence of wealthy people.  The opportunity comes from the fact that these people have no place else to go.  They will not vote Republican.  The worst they could do to Democrats is sit out the election, but the party could easily retain power if that happened.

California’s Democrat Party now dominates California’s politics to such an extent that it has a unique opportunity to confront California’s long-standing issue without paying a political price.  It’s a perfect time for Governor Brown to cement a legacy.

The post California Forecast appeared first on Center for Economic Research and Forecasting.

I have complained for years that California’s economy is not performing as it should, and it’s not working for a large part of the population, young people, minorities, less educated workers, even much of the middle class.  Those who disagree with me point out that, measured by job growth and GDP growth, California is doing better than the United States.  Therefore, California is doing great, and Bill Watkins is a cranky old hack.

Bill Watkins may be a cranky old hack, but that argument is ridiculous.

The argument that California is doing better than the U.S. and therefore doing well is based on the implicit assumption that the U.S. economy is doing well.  It’s not.

We are almost a decade into America’s weakest post-war recovery, a recovery characterized by low investment, slow economic growth, slow productivity growth, slow job growth, a falling labor force participation rate, increasing welfare rolls, and persistent high poverty rates.

It’s not like its close.  This recovery is dramatically weaker than previous recoveries.

Doing better than the weakest recovery in 70 years is not good enough for California.

At one time, the very name California was synonymous with prosperity and opportunity.  The state attracted people from throughout the world.  California was the model of the good life.

Today, California has the nation’s highest poverty rate, after consideration of housing costs.  Net domestic migration is negative, as Californians move to places like Texas and Oklahoma to find the prosperity, opportunity, and life-style they can’t find in California.  Businesses are leaving, and taking their jobs with them.  College graduates must leave to find appropriate jobs, because California creates more college graduates than jobs.  Home ownership is beyond the imagination of most young families.

California is not doing well because its policies have been hijacked by a coastal elite, which has molded policy to meet their utility functions, utility functions with no consideration for the well-being of California’s less fortunate.

California’s elite are really no different than our two presidential candidates.  Trump was born into wealth.  He was sent to the best schools.  He had every advantage.  Much of that advantage has been squandered as he followed his whims into gambling casinos, beauty pageants, reality shows, buildings, whatever attracted his attention at the time.  In his wake, he’s left failed businesses and consequently destroyed lives.  But, as they say, he’s a winner.  He’s maximized his wealth without concern for the lives of the less fortunate he’s used to maximize that wealth.

Clinton didn’t start with Trump’s wealth, but she went to the best schools, and along with her husband, has risen to the heights of power and wealth.  Like Trump, Clinton rose without concern for the lives of the less fortunate that she used to maximize her wealth and power.  From Arkansas to Washington DC and beyond, she has left a landscape that is littered with broken lives.

So it is with California’s coastal elite who dominate policy.  They have their homes and their lives in beautiful places with world-class weather and abundant amenities.  Economic growth threatens their lifestyle.  They don’t want factories or even other people’s homes marring their viewsheds.  Their attitude is that if you can’t find a job or buy a home here, well you can probably do both in Texas or Arizona.  Never mind that many people can’t afford the cost of the move.  If you live in poverty, they tell you about California’s generous safety net, ignoring the devastating impacts of a life on the dole.

Of course, California’s coastal elite who dominate policy aren’t the majority.  It seems to me that when policy is optimized for a fortunate few and actually detrimental to the interest of the majority of the population, something is seriously wrong.  Somehow, we managed to lose our way with how we select policy makers and how we make policy.

It’s not a just a California problem.  When I look at the presidential candidates and the political leaders of both parties in Congress, I see failure, failure to put competent leaders in important leadership positions.  The problem is worse in California than most other states.  Is there anywhere else in America where policy is optimized for so few at the cost to so many?

It’s difficult to believe that this is a sustainable situation.  It seems that it must reach a crisis at some point.  For California that crisis is likely to be financial, a fiscal crisis.  California’s fiscal position is fragile and volatile.  At some point, California’s under-achieving economy won’t generate the resources needed to meet California’s commitments.

California’s commitments were made based on the twin assumptions that California’s golden economy is everlasting, and there is nothing policy makers do can do to harm that economy.  Those assumptions aren’t true.  For many Californians, the state is already in crisis.  That sounds extreme, but when you can’t find a job, you have a crisis.

We need to make California work for everyone.  I’m not sure how to do that.  I am sure that we won’t make California work for everyone until we admit we have a problem.  Only then, we can start trying to find a way to choose policy makers and set up a policy infrastructure that works for everyone.

The post California Economy appeared first on Center for Economic Research and Forecasting.

It’s time for another presidential election.  Each candidate is promising new initiatives that will bring prosperity to Americans.  So, we’re forecasting vigorous economic growth?  No.

Our forecast is pretty much the same as it’s been for years, anemic economic growth as far as we can see.

Either Trump or Clinton will be president, but which one is president doesn’t matter for our forecast, because neither has a program that will generate the promised growth.

Trump’s economic plan is as brash, contradictory, and dishonest as he is.  He begins by assuming that countries compete economically.  This is a long-standing and popular misconception.  While not fans of Paul Krugman, we refer readers to his book Pop Internationalism for a readable, but sarcastic and arrogant, discussion of why this is not true.

Trump does offer tax, energy, and regulatory reform, which would increase our economy’s growth rate.  Those gains would be offset by his trade policies and his intention to export immigrants.  Decreasing trade and exporting workers, regardless of how the workers got here, are extraordinarily contractionary policies.  The plan is dishonest because he presents it as a unified pro-growth plan when he has advisors who have surely told him of the contradictions.

Clinton’s plan is as old, tired, and dishonest as she is.  It’s tax.  It’s spend.  It’s free stuff.  It’s more government.  It’s the same thing we’ve seen out of the Washington establishment for decades.  We all know, and she must know, it won’t bring the growth she promises.

We believe that presidents can have an impact on economic growth.  However, the president must be extraordinary and have congressional support, either because of party loyalty or political pressure.

President’s Kennedy, Reagan, and Clinton each initiated strong recoveries, recoveries that lasted for many years and saw several years of 4.0 percent or greater economic growth:

There were similarities between each of these presidents’ dominant economic policies.  Each relied on incentives and generally free-market solutions.  Kennedy cut taxes.  Reagan cut taxes and the regulatory burden.  Clinton expanded trade and changed welfare’s incentive structure.

We could have a similarly vigorous economy today, but the challenges are daunting.  It would require eliminating the negative incentives in three major pieces of legislation: Sarbanes-Oxley, The Affordable Healthcare Act, and Dodd-Frank.  It would also require rolling back the bureaucratic albatross that has built itself, increment by increment, into a formidable obstacle to economic growth.

Taxes should be reformed.  Eliminating taxes on repatriation of foreign earnings and on dividend income would be expansionary.

Monetary policy may be the biggest challenge to any president’s plan for a sustained vigorous economy.  It’s hard to see how the distortions built up by years of near-zero interest rates can be corrected without a dramatic decline in asset prices, a decline that would likely precipitate at least a short recession.  In a sense, the Fed has painted itself into a corner.

Whatever the Fed’s challenges, they are supposed to be independent of the other branches of government.  Presumably, the President’s only input is the nomination of the Chair and other board members.  We don’t believe the Fed is as independent of the political pressure as is advertised.  That said, it would take a very special Fed Chair to correct the current distortions.

Volker famously conquered inflation through a bold and controversial monetary policy, at the cost of what was until then our deepest recession.  The president would need to nominate and have confirmed another Volker.  We have no idea who that might be.

The four percent economic growth that Trump promises is possible, but it would require an extraordinary president to achieve it.  Unfortunately, our nomination process appears incapable of nominating extraordinary people.

The post United States Forecast appeared first on Center for Economic Research and Forecasting.

A decade of slow or declining economic and job growth has been accompanied by fundamental changes in America’s job composition.  Those changes have caused profound disruptions in the lives of millions of workers, primarily low-educational-attainment workers, and their families.

The situation is not improving.

Economic growth (GDP) appears to have slowed, even from its previously anemic pace.  Job growth has been weak too, but it’s a little better than economic growth.  Weaker economic growth than job growth implies declining or very weak productivity growth, and we’ve recently seen quarters with each.

Declining productivity doesn’t necessarily mean that individual workers productivity has declined.  It could.  If demand fell and businesses were slow to lay off workers, perhaps because of the cost of firing and hiring, individuals’ productivity would fall.

That’s not what we’re seeing now.  Instead, we’re seeing the impacts of changing job composition.  We’ve lost, and continue to lose, high-productivity jobs.  Our job growth has been in low-productivity sectors.  Naturally, high productivity jobs pay more than low-productivity jobs.

Combined, Mining, Construction, Manufacturing, and Wholesale Trade are still down over 2.5 million jobs since their pre-recession highs.  Other sectors have seen strong growth over the same period.  The generally very low paying Leisure and Hospitality sector has grown by over two million jobs.  The surprisingly low paying, on average, Education and Health sector has been our fastest growing sector.  It’s up 3.9 million jobs, almost all of which are in health care.

Technological change, increased trade, poorly incentivized safety net programs, regulation, and slow economic growth are all claimed to contribute to the change in job composition.

Technological change is an appealing explanation, but the past decade has been characterized by low business investment and slow productivity growth.  This is not what we’d expect if we were going through a generalized technological revolution.  As it is, the most visible gains from advancing technology have been in oil and gas exploration and production.  Oil prices are consequently down, but many governments, organizations, and people are doing all they can to limit or erase the gains from these technologies.

People have worried about technological change’s impact on employment since the dawn of the industrial revolution.  Time and again, those worries have proved unfounded.  I do believe, though, that the spread of electricity throughout the economy and the adoption of tractors in agriculture contributed to the persistent unemployment of the Great Depression.

The Great Depression and the Great Recession share some similarities.  So, we can’t reject the possibility that technological change is contributing to persistent unemployment, low investment and productivity growth notwithstanding.  If so, its impact is relatively minor.

Increased trade, combined with an ineffective safety net, has contributed to persistent unemployment.  This is a bit sacrilege for an economist.  If there is anything approaching a consensus among economists, it is that trade is good.  The proofs are elegant and convincing.  I have no doubt that countries that voluntarily trade are better off.  But, this ignores distributional issues, and distributional issues can be important.

As a free-trade enthusiast, I’ve argued, and deeply believe, that the benefits of free trade are sufficient to allow us to protect the workers, and the families of workers, displaced by the increased trade.  But, we don’t.  Maybe we shouldn’t expand trade until we do?

Our safety net is so bad that it actually contributes to persistent unemployment.  Means-tested welfare programs create cliffs, where small amounts of new income cause the loss of thousands of dollars in benefits.  So, why work?  Extended unemployment benefits encourage workers to be idle long enough that their skills atrophy.

Our regulatory environment is increasingly onerous, and contributes to persistent unemployment.  Perhaps the worst example is coal.  Our government has declared war on our coal industry, with the avowed goal of eliminating the industry, and by extension the livelihoods of the industry’s workers and their families.

Other regulations may be well meaning, but they are laced with pernicious consequences.  These include minimum wages, licensing requirements, and mandated benefits.

Recently, we’ve adopted more reckless ways to increase our economy’s regulatory burden.  Sarbanes-Oxley, Dodd-Frank, and the Affordable Healthcare Act are examples of massive regulations that were written in a short time in response to a perceived crisis and passed with insufficient consideration and debate.  Unemployed workers and their families pay a disproportionate share of costs of the poorly-considered regulations.

These regulations have performed one service.  For those willing to see, it’s clear that micromanaging markets by politicians and their bureaucratic lackeys is a terrible idea.

Slow economic growth contributes to persistent unemployment.  Unfortunately, it’s becoming increasingly fashionable to accept slow economic growth, or even argue that slow economic growth is good.  This is terrible thinking.  Our low and declining labor force participation rate, is one result of slow economic growth.  The fact remains that the best opportunity for a low-productivity worker exists with higher-productivity workers are employed.

How do we know when the higher productivity workers are employed?  The unemployment rate won’t help.

Unemployment numbers are distorted by labor force participation rates.  If a worker becomes discouraged and stops looking for a job, the unemployment rate falls.  The media, who engage in only the shallowest analysis, report this as if it were good news!  They say the world is better, when what really happened was that a person gave up looking for a job.  The once proud and self-sufficient worker surrendered to the soul-crushing life of a ward of the state.

The correct measures of economic vigor are labor force participation rates, new jobs as a percentage of the population, and per-capita GDP growth.  By those measures we aren’t doing very well.

What to do?

Lots of economists would say increase trade and public capital investment.  I disagree with both.  My arguments against public capital investment are here.

My reluctance to increase trade are not because I doubt the gains from trade.  Trade will increase the wealth of both trading partners.  Instead, it’s based on our inability to protect those displaced by increased trade.

Over the past year, I’ve had the opportunity to meet many men who lost their jobs because a factory moved to Mexico.  Yes, everyone was a man, and every factory moved to Mexico.

In every case, the impacts were devastating and long lasting.  Sure, some have bounced back and are now doing relatively well, but they bear the scars of divorce, destroyed families, extended unemployment, and reduced living standards.  More aren’t doing well, having slipped into a mind-numbing life of drug abuse and round-the-clock television.

We’re back to what to do?

One thing we need to do is completely revamp our safety net, in a way that always provides an incentive to work, to keep at least some of that next dollar earned.  Replacing our existing system with a negative income tax would do the trick, and save billions in administrative costs.  It would improve economic growth.  It would save families and lives.

We need to completely revamp our regulatory regime, reducing the compliance burden on businesses, embracing market-oriented solutions, and subjecting new regulation to rigorous cost-benefit analysis.

Just these two things need to be done.  Revamping our safety net and our regulatory environment would release Americans to do what they have always done: work hard, create wealth, and create opportunity.  We would see a sustainable boom, one like we haven’t seen in decades.

The post The United States Economy appeared first on Center for Economic Research and Forecasting.

Most discussions of our slow economic growth includes a seemingly compulsory demand for increased public capital spending, so-called infrastructure spending or simply “roads and bridges.”  Both Donald Trump and Hillary Clinton promise increased public capital spending on their websites.   Larry Summers made perhaps the best case for public spending when he claimed that our failure to invest in public capital creates the “worst and most toxic debts.”

I’m not buying it.

Interest rates are low as is investment, by all types of entities.  This implies that the return on investments is low.  Why should government investments be any different?

There are many reasons to believe that government investment provides a low return in the best of times.  Government investment decisions are the outcome of a political process.  One result of the political process is that one senator’s low-return project is funded in order to obtain concurrence for funding another senator’s high-return project.

The Bridge to Nowhere is an excellent example of the political process forcing low-return investments.  Fortunately, that project was abandoned due to widespread ridicule, but just as worthless projects are funded.  I just Googled “wasteful government projects” and had 538,000 results in 0.45 seconds.  You find things like spending hundreds of thousands of dollars on running shrimp and mountain lions on treadmills, $387,000 for Swedish massages for rabbits, and $18 million to renovate the airport for Sun Valley Ski Resort’s airport, and $800,000 to develop a food-fight video game.  These are hardly our most pressing issues.

The existence of low-return projects leads to a higher required return on the profitable projects in order for the average project to be profitable.

Then, there is the problem of fads.  Governments tend to make popular investments and popular doesn’t mean profitable.  After the success of the Erie Canal in 1825, other states started building canals.  Eventually eight states defaulted on their debt because of those canals.

More recently, Californians voted in 2004 to provide $3 billion they didn’t have to support stem cell research that private industry was already pursuing.

Government investment may be appropriate for projects where the return can’t be realized by the investor, or for investments that private firms won’t make because they lack information.  Neither condition applied to the stem cell research.  Stem cell research’s potential was a well-discussed topic in 2004.  The many private firms that are investing in stem cell research will have no problem capturing the returns.

Any project well known enough to carry an election fails to meet the second condition for government investment.  If it’s well known enough to carry an election, private firms know all about it.

Government projects have other costs because of the approval process.  These include the costs of lobbying, selling the project to the public, and sometimes elections.  These costs, and the uncertainty associated with them, increase the required return for profitability.  It may be that costs of approval are so high that a net-positive return is impossible.

Consider harbor expansion.  California’s ports are major import-export facilities.  Huge amounts of goods are imported through these ports, with final destinations throughout the United States.  Large amounts of goods from throughout the United States are exported through these ports.

Because of a lack of investment, California’s ports are destined to become increasingly less important.  It’s been consensus for years that these ports need larger and more efficient breakdown and distribution centers, but serious hurdles may prevent any significant improvement.

More importantly, California’s ports cannot accept the largest tankers or container ships, and there is no will to expand the ports to accept these very large vessels.  Canadian and Mexican Pacific port expansions and a widened Panama Canal will handle traffic that traditionally would go through California’s ports, if the ports could accommodate the ships.

At this point, I believe that the political costs of significant harbor expansion, and in fact any large infrastructure project in California, are so high that profitable investments are impossible.

There is also the question of government competency.  Can government still build things efficiently?  There are lots of examples that suggest maybe not:

There was the I35 Bridge collapse in Minneapolis.  California’s High Speed Train is an ongoing disaster.  Americas publicly run, once very successful, manned space program has been abandoned because of accidents.  We built an airport security system after 9/11 that is ineffective, hugely disruptive, and very expensive.  The list could go on and on.  Even public capital’s most prominent proponent, Larry Summers, has come to see this as a challenge to public capital.

Even if government was efficient and competent at building capital, it’s not clear what to build.  Proponents of more government capital look longingly back to the 1930s.  They talk about bridges, roads and dams.

Good luck building a major dam today.  Environmentally motivated resistance makes it impossible, which is good.  Dams are not an appropriate investment today.  Dam building in the 1930s was critical in bringing electricity to millions of Americans and reducing the frequency of major floods, but those gains have mostly been realized.  The return on future dams is far less.

Most of the gains from new roads have also been exploited.  Slowing population growth implies that fewer new lane miles will be needed, while drone technology and autonomous vehicles may increase efficiency of existing roads.

Dams and roads are the technology of the 20th Century.  We don’t know what the technology will drive the 21st Century, but it appears that private industry will provide it.  There have been attempts to make wireless internet service a government-supplied good, but markets seem to be providing it just fine.  Is there a coffee shop in America that doesn’t provide free wireless?

Perhaps worse, governments are essentially prohibited, because of political pressures, from some potentially very profitable projects.  Call them taboo projects.  Taboo projects cannot be built no matter how profitable they may be.  These include nuclear facilities, coal or oil based energy projects, and canals.

So.  Governments are self-prohibited from some profitable projects.  The political process requires the funding of worthless projects.  And when they have a good project, governments appear incompetent at actually building it.  I’d ask why more government projects are in the platforms of the two major presidential candidates, but I’m still trying to figure out why the two major parties selected such flawed presidential candidates.  Still, those candidates provide an excellent example of how our political process leads to far-from-optimal decisions.

The post The Perils Of Public Capital appeared first on Center for Economic Research and Forecasting.

Previously published on June 17, 2016 on city-journal.org

Never heard of fiscal dominance? Don’t worry, you have lots of company. Even many economists are unfamiliar with the term. That’s going to change, though, as more and more Western governments careen toward insolvency.

Setting aside regulation, government can influence the economy through fiscal policy or monetary policy. Fiscal policy means government spending and taxes. In the United States, federal fiscal policy is set by Congress and the executive branch working together, or not. Monetary policy is often thought of as the setting of interest rates, but it’s really about how much money is available to the economy. The Federal Reserve is the United States’ monetary authority. Ideally, fiscal policy and monetary policy are set independently. That’s why the Fed is said to be independent.

Fiscal dominance occurs when the fiscal authority is so profligate that a conscientious monetary authority is forced to accommodate the profligacy—that is, the monetary authority prints gobs of money to fund endless deficits.

For years, fiscal dominance existed on the fringes of economics, important mostly to economists thinking about fiscally irresponsible countries such as Argentina and Brazil. Italy, too, has a long record of monetary accommodation of deficit spending. There’s a reason none of these countries has achieved its economic potential—fiscal dominance has led to bad outcomes, including ever-increasing inflation, reduced trade, declining consumption, and, eventually, political instability.

Today, developed countries are finding it increasingly difficult to avoid the fiscal-dominance trap—in part because of democracy itself. It’s always tempting for political candidates to offer “free stuff” to attract votes. Once such policies are in place, it’s tough to scale them back. When the population is growing, such profligacy might be sustainable—with a younger generation, larger and wealthier than the last, coming along to pay the bills, it’s easy to ratchet up government commitments. But demographics are turning against Western governments. Birthrates are falling. Already, populations are declining in some developed countries—Japan, for example.

Before populations decline, they get older. Demand for goods and services for the elderly increases at the same time that fewer young people are available to fund those demands. The modern state could still deal with a declining population if productivity were growing fast enough, but as economists Tyler Cowen and Robert Gordon have both pointed out, it’s declining—with dire consequences.

Finally, governments’ responses to the 2008 fiscal crisis have not been encouraging. The United States responded with huge spending increases, massive expansion of the monetary base, and direct bailouts or other support for failing businesses, particularly (but not exclusively) in the financial-services industry. While the debt increase exacerbated the fiscal problems, the incentive problems in the bailout are more pernicious. They virtually guarantee, Dodd-Frank notwithstanding, a repeat performance.

In Europe, the European Central Bank sets monetary policy for several countries. Unless several of those countries have similar problems, though, the central bank should face less pressure to bail out individual governments. Of course, it’s possible—even likely—that several of Europe’s governments could face similar challenges at the same time. The pressure for monetary accommodation would then be significant. Even worse, unanticipated political pressures could compel the bank to accommodate individual countries. Europe’s response to the Greek crisis does not inspire confidence in this regard.

Moving back to the gold standard would remove monetary policy from political considerations. The gold standard, though, is controversial. Another possible approach, proposed by Stanford University economist John Taylor, is a rules-based monetary policy. The Taylor Rule is a formula that sets interest rates based on several key inputs: the equilibrium short-term interest rate, the inflation rate, the target inflation rate, output, and potential output. You feed the data into the formula, and it provides a target interest rate. The rule could potentially remove political considerations from monetary policy and stabilize economic outcomes. But Taylor’s proposal is controversial in the economics profession—and neither the Fed nor Congress nor the executive branch supports it.

And even with a rules-based approach, officials would face tremendous pressure to waive it “temporarily” in times of economic stress—just when we would need the rule most. If you waive a rule from time to time, you don’t have a rule.

All of these options—a central bank removed from a particular country, a gold standard, or a rule-based formula—involve difficult challenges in institutional design. Making monetary authorities truly independent is difficult, but vital. It will only become more important as modern governments confront the challenges of declining populations and waning productivity growth.

The post An End to Fiscal Dominance appeared first on Center for Economic Research and Forecasting.

Most commentary on California’s decision to increase the state minimum wage to $15 over time is either along the lines of it being a boon to minimum-wage workers and their families or a disaster for California’s economy.  Neither is accurate.  Different regions sill see different outcomes.  Central California, the great valley that runs from Bakersfield to Redding, once again, will bear a disproportionate burden.

Some workers’ income will increase, but hardly enough to afford a standard of living that most readers would find acceptable.  At 40 hours a week and working 52 weeks a year, the minimum-wage worker will earn $31,200 a year before taxes.  Try living on that in San Francisco or Santa Barbara.

Then, there are the workers who will lose their job, or never get one in the first place.

A $15 an hour wage would devastate some economies, but California is different.  Individuals and families may be devastated.  Regions may be devastated.  Coastal California, with the possible exception of Los Angeles and the far northern counties, will do just fine.  You will probably not be able to see an effect in their data.

Central California is another story.

California is in transition from a tradable goods and services producing economy to a consumption and non-tradable services producing economy.  Tradable goods and services are goods and services that can be consumed far from where they are produced.  Manufacturing is the classic example of tradable products, but thanks to the internet, services are also increasingly tradable.

These days, many services that were once non-tradable are tradable.  Tax preparation, legal research, accounting, and term-paper writing are examples of tradable services that were once non-tradable.  As a friend of mine says, anything done at a computer can be done anywhere in the world.

Non-tradable services are those that must be consumed where they are produced.  Lawn care, haircuts, and home maintenance are some examples.

The distinction is important because a minimum wage increase affects each differently.

The initial impact of a minimum wage increase is to increase the cost of the goods or services, tradable or non-tradable.  It’s what happens after the increase in cost that makes the difference.

Consider a minimum wage increase on one side of a street and not the other side.  You might consider walking across the street for a burrito, cup of coffee, or haircut, if the price is cheaper there.  This is the substitution effect.  It will be almost non-existent for non-tradable services with a statewide minimum wage increase.  No one will drive to Arizona for a haircut or cup of coffee.

Non-tradable services are left with only a price effect, to be discussed in a bit.

Tradable producers, though, face a formidable substitution effect.  They are competing with producers worldwide.  If they raise their prices, it is likely that enough customers will switch to other producers that tradable producers will be forced to relocate for lower-wage workers of go out of business.  If they lack monopoly power, they are unlikely to be able to absorb the cost increase.

One impact of California’s minimum-wage increase, then, will be an acceleration of California’s transformation to non-tradable services production and the permanent loss of tradable sector jobs, outside of fields like software.

It is fundamental to economics that the higher the cost of any good or service, the less that will be consumed.  This is the price effect, and it affects tradable producers differently than non-tradable producers.

Unless they have monopoly power, tradable producers will not see a price effect.  The world price will remain the same.  Total world consumption will stay the same.  The distribution of sellers, however, will change.  Agriculture is an excellent example of competitive world markets.  California will likely provide a smaller share of the world’s agricultural output.

If the tradable producer has monopoly power, the price effect may be large or small.  If it is small, they will see a small decline in sales.  If it is large, they may have to absorb the increase, sacrificing some of their monopoly profits.

Non-tradable producers will face a price effect.  How big that price effect is depends on the wealth of their customers and how essential the service is to the consumer.  A wealthy person will probably not change their behavior because of, say, a ten percent increase in the cost of haircuts.  A poor person may reduce the frequency of haircuts.

Tradable sector and non-tradable sector businesses will attempt to minimize the cost increase of a minimum wage hike.  This is most easily achieved by replacing some labor with capital.  This is the production function effect.  Assembly line workers may be replaced with robots.  Waiters may be replaced with tablets at the table, as we’ve already seen in some restaurants.

Some would argue that there is another effect, an income effect.  The idea is that the increased income, and spending of minimum-wage workers will more than offset the price and substitution effects.  This violates another fundamental economic principle, the one that asserts that there are no free lunches.  The minimum wage earner’s new income is not new wealth miraculously provided by the minimum-wage fairy.  For every new dollar the minimum-wage worker has to spend, someone else has one less dollar to spend. In fact, due to inefficiencies (distortions in product mix and markets resulting from non-market prices) created by the transfer, someone else must forego more than one dollar in order to create the dollar provided by wage increase.

Analysis of price and substitution effects implies that different California regions will be affected differently by the minimum wage increase.

Because wages are generally lower in Central California than in Coastal California, the minimum wage increase will be more impactful in Central California, amplifying both price and substitution effects relative to Coastal California.  Central California’s economy is also more dependent on tradable-goods production than is Coastal California, it will, therefore, be hurt more by the decline in tradable-goods producers.  Similarly, because Central California’s income is less than Coastal California’s, it will also see a greater price effect on its non-tradable producers.

Central California is seemingly in perpetual recession.  Even in good times, many Central California counties see double-digit unemployment.  Colusa County’s unemployment rate was over 20 percent in the most recent data release.  The region also sees disparate impacts from California’s high energy costs, water policies, and regulatory infrastructure, all of which hit them much harder.

Coastal Californians underestimate the economic differences between California’s regions.  They are huge.  California simultaneously has some of America’s wealthiest communities and some of its poorest.  It’s important that we remember that California, with about 12 percent of America’s population, has 35 percent of the nation’s welfare recipients.

Most of California’s wealthy coastal citizens never see California’s poor inland communities.  Yet, wealthy Coastal Californians — particularly from San Francisco — dominate state policy.  They implement policy as if the entire state were as wealthy as the communities they live in.  The minimum wage increase is just the latest example.

Decency would seem to require that California find ways to accommodate the circumstances and needs of our least advantaged citizens and regions.  We don’t though.  Instead we create policy that hurts our least advantaged and makes their challenging lives even more so.

The post Geography and the Minimum Wage appeared first on Center for Economic Research and Forecasting.

In popular culture, there are “good” industries and “evil” industries.

Oil has held the most hated position of the evil list for generations and is likely to hold it until there is no more oil. Farming, once solidly on the good list, is moving to the evil list because its critics claim it uses too much water and its use of pesticides and herbicides hurt the environment.

Banking holds a special place on the bad list, having resided there for more than 2,000 years. Indeed, Dante had usurers condemned to the seventh of his nine circles of Hell.

Banks still exist because they serve a valuable purpose. They are intermediaries between huge numbers of savers and huge numbers of borrowers. As such, they dramatically increase the return to savers and, just as dramatically, reduce the cost to borrowers. We need banks. We need a well-functioning banking system.

Since the Lehman Brothers collapse, banks have become even more unpopular. They are blamed for the 2008 financial crisis and the terrible recession that accompanied the crisis. Much of that blame is undeserved.

Criminal bankers didn’t cause the Great Recession. Every industry has its criminals. Surely, there were criminal acts by bankers that went unpunished but they were small players on a big stage.

Banks are among America’s most heavily regulated industries. Beginning in the mid-1990s, the federal government, with bi-partisan agreement, set about to increase the percentage of the population that owned their own home. Their methods included incentivizing banks to loan to people who traditionally could not borrow. The incentives included rewards for cooperation and punishments for failure to cooperate. Banks had little choice.

Traditional lending standards existed for a reason. Many who borrowed under the new, more relaxed, standards eventually defaulted, contributing to declining real estate values and the Great Recession.

Consolidation of bank assets in ever fewer banks is the other culprit in the financial crash. For decades now, regulations on bank mergers have been incrementally relaxed, while bank operations have been increasingly regulated. Consolidation was not a stated purpose of the regulatory changes, but they have resulted in fewer banks.

The number of United States banks has collapsed from 14,400 in 1984’s first quarter to only 5,309 in 2015’s third quarter.

The decline in the number of banks has been accompanied by an increasing concentration of bank assets. Today, only five banks control almost half of all American Bank assets.

Bank failures have consequences. Big bank failures have big consequences. The government has decided that some banks are so large, and the consequences of their failure so onerous, that they cannot be allowed to fail. Those banks deemed too big to fail are bailed out. This results in terrible incentives.

When banks merge, they claim that they are diversifying and gaining economies of scale. Research is mixed on these topics. There is evidence that our largest banks are far above the cost-minimizing scale. There is also evidence that economies of scale persist throughout the size distribution. Similarly, there is evidence that banks merge with similar banks, achieving little diversification, and evidence that diversification persists through the size distribution.

The lack of consensus suggests that banks merge for other reasons. Market power and the too-big-to-fail option are prime suspects. The typical consumer and taxpayer does not benefit from these mergers. Market power allows banks to make excessive profits. Being too big to fail encourages banks to take excessive risks.

Banks did take excessive risks and we all paid a share of the costs.

Banks, being heavily regulated, have a huge incentive to try to influence their regulatory environment. Banks hire former regulators, providing an incentive for regulators to go easy on their potential future employers.

Our largest banks are heavy contributors to political campaigns and, as we’ve learned in the current presidential contests, they have found ways to directly support powerful politicians. So, we see lots of empty verbal abuse thrown at banks but little more.

What’s to be done?

• Higher capital requirements would reduce bank runs and stabilize our banking sector. Some economists recommend requiring reserves amounting to as much as 100 percent.
• A 100 percent tax on all assets over whatever is determined to be too big to fail would eliminate too-big-to-fail banks. This, in turn, would reduce banks’ incentives to take excessive risks.
• Private deposit insurance would reduce the influence of politicians and regulators, reducing the return to banks’ political spending. Banks would cut political spending.
• Limits on market share would slow the decline in bank numbers and reduce market power.
• Differential bank regulations based on asset size would further reduce the incentive for banks to merge. Small community banks have been critical contributors to local economies. We need more of them, not fewer.

A weak banking sector has contributed to the anemic recovery. A vigorous recovery needs a vigorous banking system, focused on economic growth rather than regulation. To achieve a vigorous banking system, we need to change bankers’ incentives. We need to move past demonizing to real reform.

The post Change bankers’ incentives to get big appeared first on Center for Economic Research and Forecasting.

It is an article of faith among California’s political class that insufficient higher educational opportunities are a constraint on California’s economic and job growth.  Just about every California economic development document includes a discussion of California’s desperate need for more college graduates.

Unfortunately, the facts disagree with the faith.  California is educating far more people than it is creating jobs for them to take.  In the past 10 years, California’s public higher education system alone issued 2,455,421 degrees.  Over the same period, the state saw a net increase of only 1,136,642 jobs.

That’s right.  California granted more than twice as many post-high-school degrees as net new jobs.

We can quibble about the numbers, but the conclusion does not change. The number of degrees includes 871,922 community college degrees, including a conservative estimate of 94,000 in 2015, because data are not yet available.

If we exclude community college degrees, California’s university and state college systems still granted 1,583,499 degrees, a much greater number than new jobs.  Some of those represent one person earning multiple degrees, but more than 28 percent of students would have to have earned multiple degrees for the number of college graduates to be less than the number of net new jobs.

These numbers don’t include California’s private colleges and universities, of which there are many.  The University of Southern California, for example, granted 14,633 degrees in June 2015.

You cannot escape the conclusion that California job growth lags the rate at which the state creates college degrees.  College graduates are a significant California export.

Of course, not all of California’s new jobs require college degrees.  For example, almost 31 percent (351,926) of California’s net new jobs over the past 10 years were in the Leisure and Hospitality sector.  Very few of those jobs require a college degree.

So, why is everybody saying that higher education is a constraint on California’s growth?

Part of the reason is that education ranks with motherhood and “tolerance” on California’s pantheon of virtues, particularly among the highly educated political class, and education — notably the teachers’ unions — has a powerful lobby, perhaps the most powerful in California.

Part of it is a poor understanding of statistics.  People observe that, on average, college graduates earn far more than non-graduates and conclude that education creates higher income, completely ignoring the self-selection bias: The lowest-ability student in your high school didn’t go to college, because he was the lowest-ability student. The highest-ability student went to college because she would have been bored beyond measure holding up a “slow” sign in a construction zone.  Repeat after me: correlation does not imply causation.

Then, even after all this pumping out of graduates, there remain persistent shortages of qualified Californians to fill some jobs. Of course there are.  Nobody expects San Jose to produce all the geniuses that drive Silicon Valley’s innovation. Why should we expect them to all come from California?  These are very special jobs requiring very special skills. In this situation, large numbers work to employers’ advantage.  If the entire world is your source of these special workers, you have a much better chance of finding exactly who you need, or pay what you prefer.

The forecasting industry is a big part of the problem. It is easy to find forecasts such as this Georgetown University report that says by 2020, a whopping 65 percent of all U.S. jobs will require post-secondary education. It is just as easy to find forecasts that robots will take away all of our jobs— including in the so-called “knowledge” sector.

Long-term forecasts are extraordinarily unreliable. Long-run forecasts of necessary skill sets for future jobs are even more unreliable. They are completely dependent on assumptions that frequently prove wrong. Famously bad long-term forecasts include Time Magazine 1966 statement that “Remote shopping, while entirely feasible, will flop.” and Western Union rejecting the telephone in 1876 as having “… too many shortcomings to be seriously considered as a means of communication.”

Forecasts of increasing demand for educated workers seems to be contrary to observation. Because of computers, a McDonalds’ worker doesn’t need to know how to make change, or the price of any product. All they need to know is what a product looks like and how to push a button.

What we appear to be seeing is what my colleague Dan Hamilton calls a “hollowing out of the middle.”  Technology has increased demand for very-high-skilled people, as we see in the Silicon Valley, and it’s increased the demand for low-skilled people, as in the McDonalds example. It’s also reduced demand for many people in between, that is, the middle class.

Focusing excessively on higher education creates problems while doing no good. It is ridiculous to attempt to give 65 percent of young people a college degree. You cannot achieve that goal without reducing the quality of the graduates, which reduces the value of the degree for the better students.  This would be repeating what California has done with high school diplomas. Graduation requirements have been reduced to the point that the degree is meaningless for almost all purposes.

Increasing supply at any educational level will not make new jobs appear; in fact, many of those workers are likely to go to where there are jobs and basic costs, particularly housing, are more reasonable.  A recent study by Cleveland State University documents the ongoing migration of educated Millennials from high-cost places with few opportunities to places with lower costs of living.

Yet rather than into look how to create better paying jobs across the board, the education lobby — including many now at universities — have a perfect motivation to support more spending on, well, they and their friends. If we did achieve a 65 percent college graduate rate, we’d hear the policy wonks calling for more advanced degrees.

So, we ask, why we are creating so many more college graduates than jobs for college graduates?  I think it’s because we’ve promised our young people an education to match their abilities. That’s fair.  Government is providing a service for citizens. If it provides an educated workforce for Arizona and Texas, well that’s an unintended consequence.

We also need to ask, why is California not creating jobs for our educated young people? That’s another discussion, with lots of reasons. But, creating more college graduates is not among the answers to that question. Focusing on it diverts energy and resources from the real challenges to California’s economic growth.

The post Education and Economic Growth appeared first on Center for Economic Research and Forecasting.

California has a long history of boom and bust cycles, but over the past 25 years or so, California’s cycles appear to be becoming more volatile, with increasing frequency, higher highs, and lower lows.  The fast-moving business cycle may not provide the time necessary for many people to recover from previous busts, and may be too limited in its impact. Even now, 22 of California’s 58 counties have unemployment rates of 7.5 percent or higher. Eleven California counties have unemployment rates of at least nine percent.  And these, we are told, are the best of times.

Policy behavior is predictable throughout the business cycle.

Sacramento is awash in cash during a boom, because California’s revenues are more closely related to asset prices than economic activity.  As the economy grows, particularly in an era of ultra-low interest rates, asset prices climb faster than the economy grows, and California is flush.  Sacramento acts as if the boom will continue forever.  Spending commitments are increased, or taxes are decreased.  Politicians congratulate themselves on “fixing” the budget problem.

For Sacramento, economic busts and the resulting fiscal crisis are acts of God, completely independent of policy.  State revenues fall more rapidly than economic activity falls, because asset prices fall faster than overall economic activity. Sacramento tries to transfer the fiscal pain to local governments.  Mostly, they are successful. As of July, Local government employment was still down almost five percent from its pre-recession high, while state government employment is up about 4.5 percent over the same period.

Sacramento is currently enjoying a boom, but this boom, like all booms, will ultimately lead to a bust.  There are signs that California’s confrontation with its next bust could come soon.

Asset prices are cause for concern.  After a five-year Bull Market that saw cumulative gains of over 70 percent, the S&P is little changed this year.  Over the past 60 days, it’s been very volatile.  California’s median home price is up over 70 percent from its recession low.  It too has recently shown volatility, reflecting the huge differences between regional markets.

Housing affordability (percentage of population that could afford the median home) is down too.  It’s fallen from over 50 percent to about 30 percent.  We can’t be sure, but it’s probably below a sustainable level.  That is, below a level that can sustain a middle-class population.  Several California communities have lower levels home ownership rates, but places like Marin County have minimal middle classes.

California’s tech sector has served the state well over the past business cycle.  In quarter after quarter the Bay Area has led the state in job creation.  In many quarters, the Bay Area was the only California region to gain jobs.

But California’s tech sector can be very volatile, as the last dot.com bust in 2000 showed.  Today, venture capital investment is near the levels we saw just before tech’s big bust.  The number of deals is lower though.  It’s not clear that it is again a bubble about to bust, the possibility should be seriously considered.  Ideally, we would have a plan to deal with the subsequent fiscal challenges.

If tech does decline, the impacts will be more than fiscal.  California’s Information sector, down more than 100,000 jobs from its previous high, still has not recovered from the dot.com bust:

Recent data imply that continued economic growth, even the slow growth we’ve become accustomed to, is threatened.  California’s most recent jobs report was a big disappointment.  National data was disappointing too.  Only 20 states saw employment increases in September.

California’s position on the Pacific Rim between Asia’s manufacturing sector and the world’s largest consumer market guarantees that trade is an important sector for California.  Increasingly, however, that sector is at risk.  China’s economic growth is weakening.  Competing ports in Mexico and Canada threaten California’s trade sector, as does the Panama Canal expansion.  California’s response has been to ignore the challenges and to refuse to expand ports to accept today’s largest ships.  California’s share of North American trade will surely continue to decline:

An economic downturn would have a huge impact on California and its citizens.  California’s budget surplus is precarious, and the state has failed to make any real changes in California’s fiscal structure.  Instead of using California’s period of good fortune to reduce the budget’s vulnerability to volatile asset prices, by broadening the tax base, Sacramento has amazingly elected to increase revenue volatility by augmenting the status quo with a temporary tax.

The games that partisan politicians play leads me to the conclusion that they either don’t believe that their policies adversely affect real lives, or they don’t care.  Certainly, economic outcomes   affect real lives.  There is abundant evidence that unemployment and poverty cause drug abuse, domestic violence, broken families, poor health outcomes, and many other social pathologies.

The question, then, is do policies affect economic outcomes?  In their book Why Nations Fail, Acemoglu and Robinson compare side-by-side communities that appear identical but have different economic outcomes, cities like Nogales Arizona and Nogales Mexico.  These two cities, and the other pairs in the book, are identical, except for being in different countries.  They are adjacent to other.  They have the same resources.  They are demographically very similar.  They only differ by political regimes.   Acemoglu and Robinson find that policy decisions and the inclusiveness of the decision process have dramatic impacts on economic outcomes, and thus people’s lives.

California policy is dominated by a rich coastal elite who control most of the media, finance campaigns, rule over the universities and generally dominate all discussion.  The result is extreme inequality, persistent nation-leading poverty, high housing costs, and limited opportunity for California’s most disadvantaged populations.  And, California’s most disadvantaged will pay the most for California’s next downturn.  They won’t write checks, because they can’t.  Their net worth won’t decline, because it’s already at or below zero.  They’ll pay a far higher cost in broken homes, broken families, and broken lives.

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