Latest Blow to State: the Incredible Shrinking Private Sector

David Friedman, a contributing editor to Opinion, is a senior fellow at the New America Foundation.

Newly revised economic data vividly illustrate the difficulty of the choices confronting California legislators as they try to close the state's $35-billion budget deficit. Not only has the current recession claimed many more jobs than previously estimated, but the state's private sector, the major source of tax revenue, is shrinking at an alarming rate.

Since March 2001, when the downturn began, California has lost a net 370,000 private-sector jobs. That's 75% of the loss in the early 1990s recession, regarded by many economists as the worst in the state since the Depression.

An astounding 489,000 jobs have vanished from high-wage, high-skill industries like computers and communications, nearly double the damage suffered in the previous slowdown. Government hiring has softened the blow; 125,000 new employees, mostly teachers, have been added to the public rolls.

The gloomy employment data underscore the challenge of mounting a sustainable economic recovery by expanding the public sector as the state's tax base is contracting. The numbers also call into question the idea that a balance of tax hikes and budget cuts is the best solution for closing the deficit divide.

Those who think that continued government spending, not a reviving private sector, can be the principal engine of economic recovery fall into one of three camps: Keynesians, Washingtonians and European corporatists.

Keynesians believe increased government spending is most critical precisely during hard economic times. Severely cutting education, public-safety or health-care spending, they contend, needlessly jeopardizes everyone's long-term quality of life. Rising government spending and hiring will help the private sector recover much faster, and tax revenues will climb sooner. Government, in short, has a strong interest in priming the state's economic pump, especially when it's faltering.

Problem is, this strategy best works when the economy is poised for a quick turnaround. Unlike the federal government, most states, including California, can't carry long-term deficits. Nor can they print money to cover expenses. Even with creative accounting, state governments can balance their books only by raising taxes if business activity continues to lag. The risk is that the private economy may be too weak to absorb additional fiscal burdens. As a result, a downturn may be prolonged.

The newly revised job data strongly suggest that California's economy is far from making a U-turn and thus unable to support current state spending. Indeed, the state controller announced last week that California may have to borrow as much as $11 billion to keep the government running into the next fiscal year. Much of the government's recent expansion was fueled by the mistaken belief that the Bay Area's computer-related and communications sectors would generate enormous wealth -- and tax revenue -- for the foreseeable future. Gambling that these industries will spark a new recovery seems like a very bad bet.

To begin with, it's risky to assume that Silicon Valley still enjoys its once-unmatched ability to innovate quickly and creatively.

After the 1980s semiconductor recession, the region's network of smaller and mid-sized companies confounded expert opinion and created one of the most dynamic industrial conurbations in history. But during the height of the tech bubble, much of its unparalleled supply network was allowed to deteriorate because of skyrocketing costs, burdensome regulations and cheaper foreign competition.

No one much cared when money was cheap and wealth seemed effortless. But today, the recurring sight of U-Hauls carrying high-skill workers and entrepreneurs to other locales testifies to the region's reduced vitality. Even the most boosterish analysts publicly speculate that Silicon Valley may not fully recover until 2011 -- at the earliest.

Although economic conditions are less dire in other parts of California, they offer little promise of sparking a rapid recovery. The state's construction and financial-services sectors have held their own, but this is probably attributable to historically low interest rates and the real estate boom they have generated. Little of that growth, however, has spilled over into other sectors. In the last 12 months, more than 138,000 jobs in manufacturing, communications, filmmaking and professional services have been lost. Excluding government, only low-paying retail and food-service sectors have created many new jobs.

With no recovery in sight and with the state's budget crisis far from resolved, Washingtonians have pinned their hopes on a federal bailout. The Bush administration may politely listen to their entreaties, but it has already ruled out a big bailout for the states. Even if it softened its position, the probability that Democrat-controlled California would receive significant assistance seems quixotic, at best.

Finally, some political leaders who believe the state's economic problems can best be solved by expanding government spending want to build a state-centered, corporatist economy on the model of France and Germany irrespective of the potential economic consequences.

Largely drawn from wealthy, coastal areas where there are relatively few young families and birthrates are low -- just as in Europe -- they are more interested in quality-of-life issues, like reducing traffic or protecting the environment. These, they aver, should be state government's top priorities, not job creation or economic development.

Because of its lackluster economic record of slow growth and high unemployment, European corporatism as a model seems especially ill-suited for California, however. Wealthy, older, childless couples hardly represent the state's larger demographics, which tend to be younger and immigrant. Unless California can be magically transformed into a more upscale, less diverse population, it must have growth to survive.

Believers in sustainable government spending must thus turn to the private sector to finance their public ambitions, which means adopting a budget that puts a premium on restarting economic growth.

Essential and popular public services like education, public safety and health care should be funded.

Other programs should be either scaled down or deferred until the tax base can support them. Every state policy should be scrutinized to reduce its effect on the state's stressed economy.

So far, elected officials have not seriously tackled the budget deficit. The new economic data should strip them of any lingering illusions that a quick fix is possible. The state's private-sector tax base is as weak today as at any time in the last several decades. That's bad news for the future of state government.

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