The California economy has put up some downright ugly numbers at the end of 2007. The unemployment rate has risen over 1% since the end of 2006, and overall non-farm payroll employment has been stagnant in the second half of the year, with a  small drop over the last six months. The major question we explore in this California Report is whether this is a recession, or the beginnings of one. We review over 40 years of history, and look for the common denominators among the previous recessions in California, and how they compare to today. Three  conclusions emerge:

 

1. The major economic indicators in California move in near lock step with their national counterparts. There has never been a California recession outside of a national recession. 2. With the exception of the two most recent recessions (1990 and 2001), recessions in California show a V shape. Employment declines by an average of 2.4% over 10 months, while real personal income falls 1.2% over 12 months. The shape of these recessions comes primarily from a sharp cycle in manufacturing employment that is less relevant in today’s economy.

3. The two most recent recessions were both deeper and more severe. Manufacturing was again at center stage, but this time large permanent losses associated with structural changes in the economy created the more severe and protracted downturns.

 

Unfortunately, the current economy is hard to place on this map – we’re in uncharted territories. Unemployment is spiking, but for reasons unlike any other increase in unemployment. Some California indicators look like the beginnings of a minor recession, but both the national situation and the balance of the California economy remain ambiguous. While construction has been one of the major sources of cyclical job loss in California, it has always been the junior partner in recessions relative to manufacturing. And with manufacturing unlikely to generate job loss anything like its contributions to previous  recessions, where does the job loss come from? The current contraction in mortgage employment is likely a permanent structural change in our economy, but it is an order of magnitude smaller than the shifts in manufacturing that drove the last two recessions. And with these two very junior partners, it’s very hard to generate recession-level job losses. While we continue to forecast a very weak California economy in 2008, both its current state and future path simply do not live up to the recessions of the past.

 

Labor Market Update: A Little Worse, But No Big Surprises

With the release of the March 2007 benchmark revisions to California’s employment statistics, we can finally close the book on 2007. In December, we made several educated guesses on the direction of these revisions, and these guesses were mostly correct. Estimates of seasonally adjusted non-farm  payroll growth in California between December 2006  and December 2007 were almost cut in half, revised from 78,800 (0.5%) down to only 40,700 (0.2%) – still positive, but just barely. Unfortunately, the new numbers show an outright decline in payroll employment through the second half of 2007, with January 2008’s level of non-farm payroll employment down 0.3% from its peak in July 2007.

Revisions to the major employment categories  also mostly fell in line with December’s guesses: job losses in real estate-related sectors started sooner and fell further than previous estimates, while retail trade, professional/ technical services, and information employment all were revised upward. We did not anticipate the size of the downward revisions in leisure and hospitality employment and administrative services, but these negative surprises were somewhat offset by smaller than expected downward revisions in manufacturing. All in all, the March 2007 benchmark revision paints a moderately more pessimistic picture of the California economy, but nothing that represents a drastic departure from the themes in previous forecasts.

The other major category in negative territory is trade, whose weakness comes almost entirely from retail trade. While the contraction in retail trade  employment in the second half of 2007 looked like an ominous sign of non-housing related weakness, in December we argued that a significant portion of this  weakness would likely disappear in the new benchmark. While its overall revision was indeed positive, the retail trade sector still shed about 20,000 jobs in the second half of 2007 – a small source of drag compared to real estate, but still unwelcome. However, the 10,000 job increase in seasonally adjusted retail employment in January 2008 suggests that this weakness  may be temporary.

California’s unemployment rate was revised downward slightly, but still remains elevated at 5.9%, up 1.1% from lows in November 2006. This 1.1% increase in California unemployment over a 13-month period is something we’ve never seen outside of a recession. But as we’ve argued for months, this increase in unemployment is fundamentally different than previous episodes.

The uniqueness of the current situation in the California economy will be our focus in the rest of the report. First, we dig deep into the historical record in search of common denominators among California recessions of the past, and how our current situation compares to these historical examples. We  then explore the unemployment conundrum in more detail.

 

A Taxonomy of Recessions in California, or How Recessions are Like Pornography

While everyone can agree that the California economy has weakened significantly in the last nine to 12 months, there is substantial disagreement over whether this constitutes the beginnings of a recession, or if we’re already in the middle of one. This is most often simply a footnote in the debate over a national recession, but in many cases we hear the idea of a “California Recession” that is somehow distinct from trends in the national economy. Sometimes this discussion points to specific indicators like the divergence  between U.S. and California unemployment or the collapse in state revenues, but all too often this discussion goes the way of old-time weather forecasting:  “My knee hurts when there’s going to be a recession in California, and my knee’s been awfully twitchy lately, Sonny.” Or to attempt another imperfect metaphor, the recession (or lack thereof) is in the eye of the beholder.

Media coverage of the national and California economy has tried to cut through these inherently inconsistent opinions with a bright-line statistical definition of a recession: two consecutive quarters of negative real GDP growth. But this definition has never sat well with economists who study the business cycle. The GDP series is quarterly and prone to revision well after the fact. What’s more, by this definition there was no recession in 2001.

“A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

In the five recessions from 1948 to 1970, the average decline in payroll employment was 2.4% over an average of 9.8 months. Of course, this average hides some substantial variability: in 1960, California job growth slowed much less than the U.S. as a whole, contracting by only 0.66% over four months. The year 1948 saw the most severe recession of these first five, with a 4.15% contraction over 14 months. Variability aside, the common denominator among these first five  recessions is a sharp but short contraction in payroll employment. As we’ve discussed on numerous other occasions, this profile comes mostly from the V-shaped cycle in manufacturing employment: quick layoffs as demand slows, but rehiring as demand picks up again.

The second five recessions have less in common. The 1973 recession was late in coming to California, with local employment peaking almost a year into the national recession. The double dip recessions in 1980-81 straddle this general pattern: the first recession in 1980 was a 1.06% decline whose round-trip to recovery lasted less than a year, while the second recession in 1981 was a 2.8% decline whose round-trip took closer to two years. But again, this rough rule  of thumb of a 2.5% decline bottoming out in about 10  months isn’t too far off.

However, both the 1990 and 2001 recessions are fundamentally different than any that came before. The 1990 recession was California’s worse, with a 4.2% decline in payroll employment over 43 months. And while the overall contraction in California in  the wake of the 2001 recession was similar to prior recessions (-2.3%), it took an abnormally long time to  hit bottom (24 months), and an even more abnormally long time to recover (42 months).

Neither of the most recent recessions fit this short but sharp pattern of the other eight recessions. In both cases, this was because a structural shift in California’s manufacturing industries changed the usual layoff and recovery dynamic. In 1990, the post-Cold War collapse of aerospace employment exacerbated job loss and delayed the overall recovery, as slow intensive growth in other sectors had to make up for the lack of any quick recovery of these manufacturing jobs. A similar story surfaced in 2001: a major, permanent contraction in manufacturing without a recovery led to a prolonged weakness in overall payroll employment – except this story now held true across the U.S.

This analysis of payroll employment suggests two types of recessions. The first is a V-shaped, manufacturing driven recession, with a roughly 2.5% contraction in California non-farm payroll employment over 10 months, that almost fully recovers within the next year – sharp, but quick. The last two recessions combine some cyclical job loss (mostly in construction) with substantial permanent job loss in manufacturing, showing both deeper declines and a longer road to recovery.

Do we see similar patterns in other indicators of Californian economic activity? While there are several indicators we might look at in a historical context, the only other option that is available with a small enough lag to give some insight into our current situation is personal income. Every recession has seen a major decline in real personal income growth, with five of the eight recessions in the graph seeing real personal income growth drop below zero.

Proceeding with spider graphs as before, we see that the pre-1980s recessions once again have a similar pattern. In this case, personal income growth doesn’t peak until the beginning of the national recession, and stalls for about four quarters afterward, averaging a 1.3% contraction. By the time the recession is over (+4-6 quarters), personal income growth was essentially back to normal. The recessions that generated the quick V-shaped cycles in non-farm payroll growth also generated a short stall in real personal income growth. In the recessions since 1980, we see a markedly different story. First, in every case except one, real personal income actually peaks ahead of the beginning of the recession. Once it does peak, the contractions are both longer and deeper, averaging a 3.5% drop in real personal income over the next four quarters. Interestingly, the 1990 recession (which was much worse in terms of employment) is actually not as bad as 2001 in terms of income growth; instead, the nine quarters of falling personal income growth following 2001 was the worst recession for real incomes.

In our pursuit of historical definition of a California recession, we’ve discovered two types of recessions in California. The first is the relatively sharp but quick version that prevailed through 1980: 2.5% decline in payroll employment over about 10 months, and a 1.3% contraction in personal income over about 12 months. As we’ve noted in other reports, these V-shaped recessions come primarily from manufacturing layoffs, with a downturn in  construction providing a secondary source of job loss. In contrast to these cyclical V-shaped recessions, the two most recent recessions have had a much different character: bigger declines (averaging a 3.2% decline in employment and a 3.5% decline in real personal income), and much longer durations. Manufacturing was once again the story, with each of these recessions featuring a significant and permanent decline in some component of manufacturing.

This exercise gives us both a conceptual framework  and some statistical benchmarks for thinking about today’s slowdown. Turning first to the statistics, as we’ve already noted, the new benchmark shows that California has seen seasonally adjusted payroll employment decline 0.3% since July of 2007. On the one hand, we’ve never seen this kind of payroll decline without a recession. On the other, this decline is too small and too slow relative to our historical examples of a recession. Further confusing the matter, the most recent read on real personal income showed no growth at all in 2007 Q2, but a respectable 5% annualized growth in 2007 Q3. While the numbers and the budget crisis in Sacramento both suggest continued slowing in income growth, the slow drift downward once again doesn’t fit either historical pattern.

In the context of our conceptual conclusions, it is pretty obvious that a manufacturing-driven V-shaped recession is highly unlikely given the lack of any cyclical peak in manufacturing employment. But the potential for a structural shift is not so easily dismissed: while another collapse of manufacturing is probably not in the cards, part of the contraction in financial activities employment could have that  interpretation. During the housing boom, mortgage employment surged to unsustainable levels, and much of the current job loss in financial activities likely represents permanent job loss – financial activities employment historical has never been very cyclical. But overall financial activities employment has only declined 50,000 jobs so far, which really pales in comparison to the 358,000 jobs lost in manufacturing in the last recession. This may be a structural shift in the economy, but it’s small potatoes compared to the recession-generating structural changes of the past.

Just on the basis of statistics, we can’t really conclude one way or the other. The national economy is weaker but still holding up, and as we’ve seen that’s really the main issue in whether California is in a recession. California’s unemployment looks recession-like, but is probably overstated on the basis of a suspicious growth in the labor force. Payroll employment is contracting, and will remain very weak in 2008, but real personal income growth is also in the weaker-but-still-holding-up category.

In the face of the ambiguous statistical evidence, we have to go with our conceptual framework to determine if California is in a recession. Again, the current state of the national economy argues strongly for no. The combination of a cyclical contraction in construction coupled with a permanent loss of mortgage-related jobs could fit the pattern of the two  most recent recessions, but the size of the job losses from these sectors still doesn’t look like anywhere near enough to create the 1-2% contraction in overall employment that has been the signature of past recessions.

 

Employment and Unemployment

The unemployment rate in California has been bumping up through the last few months hitting 5.9% in December and January. Jan Hatzius of Goldman Sachs said he believes the California’s economy to be  “tanking.” The Financial Times reports that “California, the biggest state economy in the U.S., is either in recession or on the brink many economists now  believe.” Increases in unemployment, while often associated with economic contraction, are not always so. We have been looking at the weak housing market and the collapse of the sub-prime industry and their disconnect to other parts of the economy for over a year. The implication to us was higher unemployment, but no contraction in employment in the state. These unemployment numbers are consistent with our forecast from last December and do not give us pause to alter the forecast significantly. What they do, is cause us to ask, where are the unemployed and why if we are having growth is the unemployment rate so badly behaved?

First let’s take a look at the facts. California has been adding to its work force at the rate of 72,000 workers per quarter in 2007, almost one and a half times faster than in 2006. What has happened to these 288,000 new labor force entrants? Many found jobs, but not all. The California economy only created a net 26,000 jobs per quarter last year, 46,000 shy of what would have been required to keep the unemployment rate from going up. Even at 2006 levels of labor force growth, this disparity would cause an increase in unemployment. When growth in the labor force exceeds growth in the population, as it did in 2007, the labor force participation rate goes up. This occurs sometimes in a bad labor market as families try to field multiple workers to make ends meet, but the usual response is for participation rates to go down. Prior to 1970, when women in the labor force were less common, there were recessions where increased unemployment brought increased labor force participation. Since then, in every recession, with the exception of the second dip of the double dip recessions of ’81 and ’83, has seen labor force participation rates decline with deteriorating labor markets. The reason is that in a tough labor market, people looking for a job and not finding one get discouraged and go do something else. They might stay in school longer, go to law or graduate school, decide the time is right to pursue some creative or entrepreneurial interests, do volunteer work, or postpone coming back into the labor force after staying home with the kids.

One does not expect labor force participation to go up when labor demand is going down unless there is a philosophical change in attitudes towards market-based work. The year 2007 did not see such a change occur. We know that there are weak localized labor markets in California. Those areas most exposed to  the housing crisis, the Central Valley, Inland Empire, and the Central Coast, as well as Orange County did not add much if any jobs to their regions in the 2007.  So, logic tells us that the regions of California which were growing might be doing sufficiently well to induce people away from school, art, and home production and into the market place to create the double growth of unemployment and employment.

The real story of employment in California in the 4th quarter is the unevenness of the growth. When looked at by regions, we see Los Angeles and the Bay Area doing reasonably well, San Diego and Inland Empire in the positive zone, and the balance of the state limping along between positive and negative or just negative. On a year-over-year basis, California gained 104,000 jobs in Q4 2007. Most of these were in Los Angeles and the Bay Area.

From the 3rd quarter to the 4th quarter the Inland Empire, hard hit by the slowdown in container imports, and heavy exposure to sub-prime and other exotic mortgage financing, showed signs of job growth. In part, this is due to the fact that employment, as reported in the household survey, is by residence of the employee and there are a large number of Inland Empire residents commuting to Los Angeles. The other source of job growth came from the service sectors catching up to the rapid growth in the population (the region grew by 347,000 people from 2005 to 2007).

So, a little less than half of the increase in unemployment in California is due to the inland regions, central coast and Orange County where employment is contracting. Looked at this way, the sharp rise of unemployment in California is less a symptom of a state slipping into a recession as it is a manifestation of a state comprised of many different regional economies. Finally, we should comment on the job loss reported for January. On a seasonally adjusted basis the state lost about 20,000 jobs. This is roughly the amount of jobs lost in the movie industry alone due to the WGA strike. Since the WGA strike was a temporary work stoppage, and is now settled, we do not read too much into this one month job decline.

 

Forecast and Conclusions

Our forecast is for a very weak California economy in 2008. The double whammy of construction and financial activities job loss will continue to drag at the economy, keeping overall job growth slightly negative for two more quarters. The unemployment rate will top out at 6.3% by the end of the year, and real income and real taxable sales will both show small losses in the first half of the year.

Yet, we maintain that this very lackluster economy should not be described as a recession. First and foremost, there has never been a California recession without a national recession, and we are not forecasting a national recession. While the continuing loss of mortgage-related employment does fit our conceptual model of a structural shock to the economy (like 1990 and 2001), both the current state of the California economy and our forecast fall short of the weakness in previous historical episodes that we’ve chosen to label recessions. Both statistically and conceptually, today’s economy is something new — stinky, but new. Based on comparing the current economy to past recession episodes, we once again conclude that real estate weakness will remain a significant drag on the economy, leaving us treading water in 2008 — but not slipping under the waves into recession.