Economist Thornberg: ‘We’re not out of the woods’ 

Editor’s note: Christopher Thornberg, founding principal of Beacon Economics and a nationally regarded expert on economic trends, discussed fiscal conditions for 2010 during the California School Boards Association’s Forecast Webcast in January. The views expressed here are his own. These edited excerpts hit the highlights. A video archive of the complete Forecast Webcast—including why Thornberg says the consumer is “what worries me most”—along with presentations by CSBA President Frank Pugh, Executive Director Scott P. Plotkin and Assistant Executive Director for Governmental Relations Rick Pratt, as well as Jannelle Kubinec, associate vice president of School Services of California, Inc.—is available at www.csba.org/TrainingAndEvents/Events/Forecast.aspx .

There’s some fairly good news out there—the economy, housing, has been in a bounce over the last few months. In fact, the big question on everybody’s mind has been how real, how sustainable, is this bounce overall?

The good news is quite clear: The recession is over. The National Bureau of Economic Research will probably come out in six or seven months with one of its very accurate “backcasts” and tell us, in fact, the recession ended officially in August or September of 2009.

The problem is this: The recovery we are seeing in the economy today is not a function of fundamentals. It’s a function of government policy. What we’ve seen over the course of the last year is one of the largest interventions in the economy by the federal government ever. The problem here is that these stimuli are creating their own set of potential problems, and as such, eventually the government is going to have to back off. When they do, I fear that the problems in the economy that put us into the recession in the first place—namely, the overall asset bubble, housing and, most of all, the American consumer—these problems are going to re-emerge, and it’s going to make any sort of recovery quite weak, which has profound implications for what the budget situation will look like here in California over the next couple of years.

So, what’s next?

We have to keep in mind that the state really has never put into place proper solutions to the budget gap that emerged through this particular downturn. The fact that we haven’t used proper solutions implies that we’re going to continue to see budget gaps in coming years, despite the fact that revenues are now at bottom and are going to start to come back up again.

As for the school districts, I have one bit of bad news: While the overall state budget has stabilized, local revenues—primarily property taxes—have not. Assessed valuations, the driver of local property taxes, are such an important source of funding for local education. Those hits are just beginning now, and unfortunately this implies that school districts are going to continue to see their budgets being squeezed over the course of the next couple years.

Over the course of the last year, we saw one of the largest downturns in Gross Domestic Product we’ve seen since World War II. Unemployment in the U.S. hit double digits—10 percent—in 2009. Here in California, unemployment reached something on the order of 12.5 percent. We’ve lost almost a million jobs over the course of the last couple years in California. The hit has been widespread.

Why is California being hit worse than the rest of the country? There is a line of thought out there that California’s economy is suffering from its years of high taxes, too much regulation, and a lack of leadership in Sacramento. Even if you do believe that, I would make the argument that all of those factors were in place in 2004 and 2005, when the economy was growing quite well. Clearly, something else is going on here.

The answer is that California is a highly cyclical state. Our economy is heavily exposed to the cyclical parts of the U.S. economy—business spending, for example. With the big collapse of the world economy and decline in exports, it hurt California substantially.

And, of course, California is a real estate state. The boom and the bust here is one of the worst in the nation, causing things to be very difficult. We live in a state in which, when times are good, it’s very, very good. Unfortunately, that also means when times are bad, it’s very, very bad. But the key point is that these are short-run phenomena, not long-run trends.

So, how real is this resurgence?

We’re not quite sure how robust this recovery is. The financial markets see this as a light at the end of the tunnel; the stock market has been rising tremendously.

Unfortunately, other indicators don’t paint such a rosy picture. Capacity utilization, for example, remains very, very low. Which means that while business investment has stabilized, there doesn’t seem to be a big resurgence in business spending in the near future.

We’re also seeing some decent, but not great, numbers on the consumer front. Overall retail sales have been coming up, but remain largely below where they were a couple of years ago.

What kind of recovery?

Wall Street is talking about the V-shaped recovery. Most economists are talking about a U-shaped recovery—we drag along the bottom for quite some time. Others are talking about a W-shaped recovery; this would be the double-dip, where the economy moves into recovery before it slides into another recession to move forward again.

A couple years ago, I saw fundamentals that were seriously out of whack. We knew it was those fundamentals that were going to cause big problems in the U.S. economy.

But today, the economy is not being driven by fundamentals. It’s being driven by policy. Recovery will be slow, because the problems that put us here in the first place have not been completely solved.

Let’s take a quick look at housing. We know that housing starts hit bottom in the United States overall. Housing permits in California have come up just a little bit. We have actually seen a little bit of increase in housing prices in the U.S. economy and here in California.

The big problem, of course, has to do with mortgages. You may have heard discussion of a “shadow inventory” of houses out there. In this case, the shadow inventory is problem mortgages, mortgages that should have been foreclosed on but have not been because of various policies that have simply delayed the process.

The issue here is that the problems have not been solved. The Mortgage Bankers Association said that, in the third quarter of 2009, something on the order of 12 percent of all mortgages were nonperforming in the United States; that’s 16 percent here in California. That is to say, 16 percent of all mortgages are seriously delinquent or somewhere in the foreclosure process. This is 400,000 to 500,000 housing units that are eventually going to have to be put on the auction block. When this occurs and those units hit that market, this little rebound we’ve seen in housing will come to an end. That, of course, is an issue for the overall economy.

We also have a commercial crisis. We saw asset prices go through the roof on the basis of easy liquidity. Unfortunately, the revenues these commercial properties could generate simply didn’t substantiate these prices. Many, many investors are deeply underwater on their loans to various banks. Eventually, cash flow issues are going to catch up with a lot of these investors, and when they do, these properties are going to start being foreclosed on. That, of course, implies that this part of the California economy has yet to really suffer from the big downturn that the rest of the economy already has.

So, my forecast is still not very good. Many of our problems have been worked out of the system, but some still remain. Consumers are still not saving enough. The housing market still has to work through a lot of foreclosures before things can truly get healthy. There’s lots of uncertainty, and lots of uncertainty means the best we can say about the next couple years is that it will be a weak recovery.

State budget

What does this mean for California’s budget? Good news and bad news. The good news is pretty clear—the collapse in state revenues has come to an end.

But bear in mind two things: while the revenue side of the equation may be stabilizing, the expenditure part has not. Also important is the assessed valuation front. History says that assessed valuations on properties lag the housing market tremendously. As a result of that, the real problem with declines in assessed valuation due to that record drop in property prices has yet to hit the California economy. Prices were dropping at 20 percent per year for a couple years. Overall prices in the state have come down by nearly 50 percent from the peak they reached a couple years ago. What this implies is that for the next couple years, we’re going to see a pretty sharp pull-back in assessed valuations.

We’ve done some of these valuations on a place-by-place basis for a variety of school districts that we’re working with right now, and some places are truly better than others. Nonetheless, expect a big hit to that portion of the revenue stream as we move over the next couple of fiscal years.

So, wrapping up, the recession is clearly over, but we’re not out of the woods. Consumer weakness is going to continue. Business is a bit of a wild card. The housing bounce won’t last. Banks aren’t out of the woods, but most of the troubles are just starting to heat up now. There is a chance of a double-dip recession, but that’s fairly low given the different policies the feds may pursue. And higher interest rates definitely will be coming down the pike.

It’s not the end of the world. It’s just a matter of time before we work our way out of this mess, and that requires a little bit of patience. We’re going to get through this, but there’s a little more time until we work our way through these problems and start thinking again about growth and prosperity.

‘We have to make sure kids have an education’

Editor’s note: Following economist Christopher Thornberg’s main presentation at CSBA’s Forecast Webcast in January, CSBA Executive Director Scott P. Plotkin posed a question suggesting that states may deserve the sort of economic aid the federal government doled out to big banks, automakers and insurance giants. “If AIG was too big to fail, couldn’t the same argument be made for California?” Plotkin asked. “Absolutely,” Thornberg replied, going on to add:

It’s an interesting question. Not too long ago there was another analyst in the state who made some comments that got the bond market riled up, that the state may actually default on some of its bond debt. Of course, that’s silly. There are certain priorities in the state: the No. 1 priority in terms of funding in the state is education, and then No. 2 is debt service. For us to actually lose that much revenue would be basically completely unheard of.

Nonetheless, if it ever got to the point where the state started running out of cash because of bad planning, you can bet that the federal government would have to step in and help the state out, at least with its bond debt, if nothing else. Because realistically, you just can’t have that kind of turmoil in the debt markets right now.

They’ve stepped up to the plate and virtually guaranteed all losses to [Fannie Mae and Freddie Mac, the government-sponsored enterprises to facilitate home ownership] moving on into the future. They’ve stepped up to the plate with AIG to the tune of hundreds of millions of dollars, and you have to ask yourself, “Why aren’t they using a small amount of that cash to help some of the various states?”

But there you get into parochial interests. The problem here is that if you start giving California some money, everyone is going to want some money, and you open up the dam walls and they’re afraid there’s going to be this flood of states requesting funding. And I think that’s where the resistance lies for our state representatives in Washington, D.C., right now.

We’re at a very interesting point in time. This nation has shed 7 million jobs. As we come out of this, we’re going to see some important changes happening in our labor force. Over the 1990s and into the start of the last decade, we saw an enormous increase in information technology, how cheap it became and all the things we can do. That was never really fully integrated into the labor force.

You’re going to start to see a lot of these information technology solutions, cost-cutting, capital investments being put into place. And that means really two things. It means a) the labor market is going to recover slowly, and b) now, more than ever, we have to make sure kids have an education. Because those sorts of jobs that were there for low-skilled workers that were decent-paying—they’re gone. They’re just not going to be there. So we need to double our efforts to making sure these kids get educated.