Why California Is Doomed   (March 9, 2010)

California is doomed for two simple but profound reasons: the cost structure is too high for most businesses to survive, and a boom-dependent economy.

The dysfunctions crippling California would easily fill a volume: a dysfunctional Legislature that has been gerrymandered to protect virtually every seat; a dysfunctional proposition system which enables special interests to craft Protected Fiefdoms via the ballot box; recalcitrant public unions who don't see anything wrong with public servants getting 90% of top-pay in pensions while still earning big bucks as "contract employees," an enormous population of undocumented workers who pay only sales taxes, and whose employers pay no payroll taxes, either-- and that just scratches the surface.

I want to highlight two systemic, structural causes for California's impending bankruptcy as a state and as an "economy": a crushingly high costs structure and an economy entirely dependent on the next boom.

I know this sounds too simplistic to be meaningful, but I think there is much truth in this statement: Costs are too high because the guy before you paid too much.

In other words, you can't afford the $500,000 mortgage on the $625,000 house you bought in 2008 because the guy before you paid $550,000 for a house which sold for $140,000 in 1997.

These numbers are drawn from reality: our friends bought a small home in a desirable suburb in the San Francisco Bay Area for $140,000 in 1997. Yes, it was a fixer-upper and yes, our friends completely remodeled it. The fair value of the house after renovation was probably in the $175,000 to $190,000 range, tops.

They sold the house in 2005 for $550,000, and that buyer unloaded the house in 2008 for $625,000.

This represents approximately $235,000 of actual value (the $175,000 adjusted for inflation from 1997 to 2010 as per the BLS inflation calculator) and $390,000 of "credit-bubble" excess.

Yet that "bubble valuation" is an actual cost now that somebody borrowed money to pay that grossly inflated price. This mechanism is absolutely key to understanding the California economy's fundamental insolvency: the apartment rent is high because the landlord overpaid, the office rent is high because the landlord overpaid, the house is too high because the previous owner overpaid and his/her lender ponied up the mortgage based on bubble valuations.

You can see the bubble in this chart of median home prices in Califonia:

It even explains why Napa Valley is going bust, as this story submitted by frequent contributor U. Doran reveals: Vineyard Defaults Surge as Bargain Wines Hurt Napa Valley.

Wine costs are partly driven by the fact that the last guy grossly overpaid for vineyard land. Now the lenders are scrambling, but it's all too late; bubbles burst, and sadly for the lenders and those who bought at the top of the bubble, there will be no boom to save them.

Hunkering down and awaiting the next boom is a strategy as old as the state itself. When the easily plucked gold in the Sierra Nevada ran out, the economy based on supplying distant mining camps died right along with hundreds of those camps.

But then the Comstock Lode of silver was discovered in Nevada, and California--especially San Francisco--was bailed out by a veritable flood of fresh wealth pouring out of the mines.

More recently, the fall of the Soviet Union in the early 90s gutted the defense industry which had been a mainstay of the California economy since World War II. That "depression" lowered real estate values and caused many bankrupcties, personal and business alike.

But then the biotech and personal computer/software revolution took hold (the Macintosh took off as the laserprinter revolutionized desktop publishing, etc.) and the next boom was under way. Tax revenues skyrocketed and Silicon Valley was the envy of the world, sparking wannabe "incubators of wealth" from New York (Silicon Alley) to Malaysia and beyond.

While no boom runs white-hot forever, the residents of California have come to expect a new bubble/boom to arise to fuel rising tax revenues and real estate valuations. Just as the PC revolution peaked (1995's "Start Me Up" Windows launch (as the bumper sticker had it, "Mac 1985, Windows 1995"), then the Internet boom started, triggering a frenzy of overinvestment and bubblicious valuations.

After that bubble burst in 2001, hot-spots in San Francisco and the valley lost some luster, and about 120,000 workers lost their jobs and left Northern California. But once again, a new wave of web-enabled businesses arose: Netflix, the Google juggernaut, Apple reclaimed the crown of global device/software integration innovation, Twitter, etc. etc.

But the current Web 2.0 boom is not generating a flood of new wealth which spreads over the landscape. Twitter has about 100 employees and might double to 200. Apple employs a few thousand people in Cupertino but all its manufacturing is done elsewhere.

What nobody seems to notice is that Web 2.0 is all about leveraging automated software. You don't need 10,000 people to run Twitter or Facebook.

And as I noted yesterday, these Web 2.0 businesses based on advertising revenues are inherently limited to the pool of available advertisers whose adverts are actually generating revenues. You can't reinflate a trillion dollars of real estate with 200 employees.

California is now the world capital of Denial. Everyone from the State legislature to union officials to realtors to small business owners are hanging on, refusing to face the fact that there will be no boom to save them and the state, To survive one more year, they're borrowing money, hiding debts and real valuations, monkeying with the books and playing accounting tricks, borrowing from next year's revenues, selling bonds--anything to maintain the artifice of solvency for 2010 so the next boom (conveniently scheduled for 2011) will lift real estate values, create hundreds of thousands of high-paying jobs and launch entire new industries.

Welcome to the Golden State of Denial. Without another global bubble--for California is a global economy--then California is doomed to insolvency at every level, public and private.

A return to historical levels of real estate valuations will bankrupt every lender and every owner with debts based on bubble valuations. State and local governments are thus doubly doomed, as their property tax revenues dry up and payroll taxes dwindle along with the job count.

I have covered the pernicious effects of a high cost structure before: Lowering the Cost Structure of the U.S. Economy (August 29, 2008)

California's entire cost structure is based on bubble/boom valuations and the vast tax revenues generated by those bubbles/booms.

The problem in California is everything costs too much: auto insurance costs more, gasoline costs more, taxes are near the top, especially on those households who make more than $100,000 a year, sales taxes are basically 10%, workers compensation insurance, business licenses, vehicle taxes, State Park admission/parking fees, rent, housing, and on and on.

The state and all its local governments have grown fat on endless bubbles and booms, and are now refusing to face the long lean years ahead. California is like the pilgrim who gets saved by a miracle at every turn. The economic miracles can't run out, because we've always been saved before.

As the disclaimer puts it: past performance is not a guide to future performance.

In some ways, California's dependence on bubbles and booms mirrors the nation as a whole; as with so many things, California has just extended the fantasy further.

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