Bromides and Nostrums: Dubious Prescriptions for What Ails California's Economy

By Jock O'Connell

(An edited version of this article was published in the Sacramento Bee on May 9, 1993.)

With California in the grip of its harshest economic times since the Great Depression of the 1930s, the folks over at the State Capitol are understandably under a lot of pressure to put things right. But whether any of the various bromides and nostrums they're kicking around these days will have any positive effect is open to doubt. Not only is there the usual ideological head- butting over the role government should play in economic affairs, altogether too much of what many of our leading politicians and most influential pundits have been saying about the state's economy bears little relationship to how contemporary businesses are run and how a highly diverse and dynamic economy like ours functions.

Among the more prevalent errata are: the popular but misconceived notion that an allegedly hostile "business climate" is at the root of the state's economic ills; a misplaced confidence in the use of tax credits as a spur to job creation; a myopic pre-occupation with manufacturing; a proclivity for exaggerating the importance of small businesses in creating jobs; and a failure to appreciate the extent to which, for most practical purposes, there is no such thing as "the" California economy.

And that's not the worst of it. Decision-makers in the nation's largest state don't even have credible numbers on which to base public policy. Consider the case of the "Phantom Labor Force," a veritable legion of California workers who never existed -- except in the state's official employment figures.

According to the widely cited estimates of the Department of Finance, some 800,000 jobs have been lost in California since the summer of 1990, when employment levels, having peaked at around 12.8 million, began to decline after nearly a decade of remarkable growth. There's just one small problem, though. For over two years now, federal and state labor market analysts have known that actual job losses in California have been at least 200,000 and perhaps as many as 300,000 less than what has been officially reported.

Why the discrepancy? Patricia Getz, the chief labor market economist for the U.S. Bureau of Labor Statistics, says that auditors from her agency and from the state's Employment Development Department discovered in early 1991 that employment figures dating back to the early 1980s systematically overstated the number of jobs in the California economy. The culprit turns out to have been the casual attitude with which numerous employers and payroll accounting firms approached the task of reporting employment data to government agencies. In many instances, what was being reported was the number of paychecks issued rather than the number of workers receiving paychecks. Thus, individuals who received a separate check for overtime work frequently wound up being counted twice for employment data purposes. Not surprisingly, job figures showed a precipitous drop in California's employment rolls after the reporting rules were tightened up in 1991. But, as Getz explained: "What looked to many like job loss was actually the result of an accounting change. We just stopped counting jobs that weren't there in the first place."

Even though revised employment data for the years 1982-1991 (due to be published by EDD early next month) are apt to show that this recession has been less traumatic than originally thought, it is likely that state officials will still feel obliged to help restore vitality to California's economy as soon as possible. Yet at a time when even the federal government seems lacking in counter-cyclical powers, economists positively scoff at the notion that state governments have the ability to turn their economies around in the short-term. Needless to say, elected officials -- generally as purposeful as they are impatient -- don't like to be told that they are pretty much marginal players when it comes to stanching the hemorrhage of jobs and getting the economy back on track.

But that's what economists have generally been telling California's political leaders, albeit not in so many words. Apart from conservative supply-siders like Arthur Laffer, whose omnibus cure is to cut taxes, most economists probably agree with the Harvard Business School's Michael Porter, who holds that the fundamental economic responsibility of state and local authorities is to maintain the foundation for prosperity by investing in education, worker training and infrastructure. In an intriguing December 1992 report entitled "Toward a Shared Economic Vision for Massachusetts," Porter writes that "What determines prosperity today is the potential of a region's industries and entire economy to continuously upgrade." Yet those sorts of things ultimately involve hefty expenditures on projects which are less than glamorous and which produce few immediate results. To officials struggling with chronic revenue short-falls and budget deficits, that kind of economic advice seems at once gratuitous and politically naive.

On the other hand, what worries people like Stephen Levy and Robert Arnold at the Palo Alto-based Center for the Continuing Study of the California Economy is that the state's political leadership, under the gun to do something, will permit political expedience to shove economic efficacy to the side. And this is precisely what seems to be happening. In effect, they have rejected the standard analysis which attributes California's current economic ills to such factors as a shrinking defense budget; corporate reorganizations, mergers and downsizings; and a prolonged case of economic doldrums here and abroad. Instead, searching for a meaningful role for themselves to play, they have redefined the causes of the state's economic ills to suit the modest policy tools they have at their disposal. This is why the cause celebre among both liberals and conservatives at the Capitol these days is the presumed need to repair California's tarnished "business climate."

Those Business Climate Blues. It is widely believed that something has gone singularly wrong with the Golden State's business climate and that, unless the problems are soon fixed, California will continue to lose jobs to states with a more accommodating attitude toward private enterprise. According to Republican business paladin Peter Ueberroth, "California's economic wounds are mostly self-inflicted." Along with Governor Wilson, most of the state's leading business organizations and a growing number of liberal politicians, Ueberroth (who chairs the Governor's Council on California Competitiveness) points an accusing finger at an intolerably expensive workers compensation insurance system, high taxes and fees, excessive regulations, and government bureaucrats who are thought to delight in tying businesses up in knots of red- tape. As a consequence, there has reportedly been a "sharp outflow of business enterprises and jobs from California" (to quote a statement made the week before last to the Bee's editorial board by Jerry Jasinowski, president of the National Association of Manufacturers).

While the legitimate complaints of business people should hardly be shrugged off, the truth is that Ueberroth and Jasinowski are both trafficking in hyperbole and misconception. Although perhaps not falling into the same category as other contemporary urban myths like alligators in the sewers, all this talk of job flight from California has subsisted strictly on a diet of rumors and anecdotes. It is certainly not based on the kind of empirical evidence responsible economists like to see. In fact, there are no sources of systematic data on the movement of manufacturing plants into or out of California.

To be sure, there are companies packing up and moving elsewhere because they can no longer afford to do business in California. But there's nothing new about that. Even during years of rapid economic growth in California, firms relocated to other states or countries, just as hundreds of American companies have sought out less costly manufacturing sites in Asia or Latin America. While such corporate decisions had created despair among union officials and their political allies, not to mention the towns and workers left behind, the intrinsic benefits to the U.S. economy have long been attested to by, ironically enough, many of the same people and business groups who now profess to be so horrified by job flight from California. Why else would responsible organizations like the California Chamber of Commerce endorse the proposed North American Free Trade Agreement?

The real issue is whether an abnormally large number of firms have been leaving the state of late, and the answer appears to be no. Those who study California's economy closely -- people like Federal Reserve Bank of San Francisco economist Carolyn Sherwood-Call -- state flatly that there are no indications of a unusually large migration of business out of California. And as for Peter Ueberroth's highly publicized lament that California's business climate is "the most highly tuned, finely honed job-killing machine that this country has ever seen," even a recent analysis of California's economy commissioned by the California Business Roundtable concedes that "no data are available on the loss of jobs due to the business climate." The best estimate, according to Adrian Sanchez, a regional economist at First Interstate Bancorp's Los Angeles headquarters, is that the number of jobs lost in California over the past couple of years due to business climate factors is "quite small."

Furthermore, there is nothing surprising about all the grousing being heard about California's business climate. The role of a recession -- apart from weeding out badly managed firms -- seems to be to invite complaints about taxes and regulations for the simple reason that declining profits make company executives more acutely aware of the costs of doing business. Perhaps taking a page from the behavior of other groups in what social critic Robert Hughes calls the American "Culture of Complaint," business people now proclaim themselves to be oppressed victims in need of their own version of affirmative action -- namely tax breaks and regulatory relief. But boardroom fashions change with economic cycles. During the expansionary years of the mid- 1980s, it was not uncommon to hear the CEOs of California corporations deploring the quality of public education, the lack of serious worker retraining programs, and a crumbling infrastructure of roads, bridges, ports, and waste treatment facilities. With any luck, business organizations will soon be back griping about how California can hardly expect to sustain high- technology aspirations by ranking 41st (just above Louisiana) in education spending per pupil.

The belief that California's business climate somehow went uniquely sour -- presumably around the time George Deukmejian was turning the reins of power over to Pete Wilson -- seems particularly silly to those of us who monitor business conditions throughout the country. Even the chorus of lamentations one hears voiced about California's workers' compensation insurance system are echoed in practically every state in the Union. (For instance, last December 15, the Boston Globe reported that workers comp costs in Massachusetts were continuing to rise despite the enactment of reforms two years earlier -- reforms reminiscent of those now being passed in California.) And as for the comments of California executives about the much better treatment they receive from government officials elsewhere. the plain fact is that states invariably assign their most cheerful and cooperative bureaucrats to their business recruitment offices. Anyone who thinks that companies already doing business in a particular state get the same treatment is too simply naive to be in business.

The Myth of "The" California Economy. Virtually every discussion of California's economic problems implicitly assumes that we are talking about some unitary entity whose boundaries are coterminous with the state's political borders. But, as periodic suggestions that California be carved up into two or more states remind us, there are actually several "Californias," each with its own distinctive geographic, demographic, economic, and even political characteristics. And, just as some companies or entire industries may thrive in a business climate others find intolerably oppressive, some regions of California have fared much better than others during the current recession and have much brighter economic prospects for recovery. As The San Francisco Chronicle noted last month in its annual review of Northern California's best companies, 82% of the region's 100 largest companies posted increased sales in 1992 as opposed to 77% the previous year. Moreover, 14 of the region's top 20 employers actually added positions in 1992. As the report concluded: "Companies in northern California are showing some compelling signs of a rebound, despite the fact that California has the weakest economy and the highest unemployment rate in the country."

What is less evident is the degree to which California is coming apart as an economic unit. New economic clusters are today being forged as key industries sprawl out from the traditional hubs of Greater Los Angeles in the south and the San Francisco Bay Area in the north. Not only are these new clusters spilling across political boundaries, the commercial links being forged with industries outside of California are, in the long-run, likely to be more significant than whatever residual economic glue may still bind them to other regions of California. For example, Southern California and Arizona are coming to resemble a coherent economic unit (especially with respect to aerospace and defense industries), just as the border between Mexico and San Diego County is being blurred by companies linking up with firms in Baja California. Meanwhile, Silicon Valley's electronics industry is in many respects more closely linked to Asia (and Texas) than it is with Southern California. As these trends continue, economic measures intended to deal with the problems of "the" California economy may be addressing a convenient fiction.

The Job Creation Tax Incentive Giveaway. Here's a case where some liberal politicians, in casting around for ways to stimulate job creation, are floating a proposal -- now being considered for inclusion in the Assembly Democratic leadership's omnibus tax reform measure -- that has business executives absolutely chortling in anticipation of free money. Under this scheme, companies adding new jobs paying more than a certain wage (usually $18,000-$20,000 a year) would qualify for a state corporate income tax credit which, depending on whose version you're looking at, would range from $1,500 to $2,500.

As with many proposals involving tax expenditures, this one is unaccompanied by any real analysis of its probable costs. But in an economy as large as California's, where even a mild recovery would see the creation of tens of thousands of jobs, the hit on the state treasury could be enormous. But beyond its unexplored fiscal implications, the proposal also misunderstands business's attitude toward job creation. In reality, most employers are no more concerned with job creation than the producers of pornographic films are with plot development. This is no slight on corporate executives. As conservative economists like Milton Friedman like to emphasize, businesses are not welfare agencies. They exist solely to make profits. And in today's business culture, the market rewards firms which achieve productivity gains, not increases in employment. Indeed, the most successful companies are seen to be those which manage to boost output while simultaneously shedding workers. Given such market disincentives, there is little reason to expect that very many companies will take on new workers merely to qualify for a credit against their state corporate income tax bill. But companies which do add workers because of rising demand for their products will gleefully claim the tax credit, more appropriately regarding it as merely a bonus on top of the reward already bestowed by market forces.

The Small Business Mystique. Like family farms, small businesses are widely thought to be the repository of certain entrepreneurial values -- and, inevitably, a whole host of populist myths -- which society (or at least that part of it which never read Sinclair Lewis) wishes to perpetuate. For politicians, the principal charm of small businesses stems principally from the oft-repeated claim that they create the vast majority of new jobs. But as a March 1993 report prepared for the U.S. Census Bureau by a team of independent economists concluded: "Conventional claims about the job-creating prowess of small business range from misleading to fallacious."

While most of us intuitively conceive of small businesses as being enterprises with no more than 50 or 100 workers, the U.S. Small Business Administration defines companies with as many as 500 employees as small businesses. By that definition, fully 99.7% of all California businesses are small. So it is hardly surprising that small businesses, which employ 80.8% of all California private sector workers, should account for the bulk of any new jobs.

The picture changes if we break down the small business category and examine how each sub-category's share of the California labor force has changed over time. Everybody knows that the state's very largest employers have been downsizing for several years now. And sure enough, their share of the state's private sector labor force did shrink during the 1980s. Remarkably though, the same thing happened to businesses with fewer than 20 workers. By contrast, the sub-category which saw the greatest increase in its share of the workforce was that composed of firms employing between 100 and 249 workers. What this suggests is that the most significant contributions to job creation among small businesses are largely attributable to companies which many of us may not regard as being small.

More importantly, job creation is not randomly distributed across the spectrum of small businesses. According to Bruce Phillips, chief economist at the U.S. Small Business Administration, small firms -- once established -- generally account for little new employment growth. Instead, job growth comes primarily from two sources: the creation of new firms and the rapid growth of a modest percentage of companies that are fast on their way to becoming large businesses. Another student of small business behavior, David L. Birch, concurs. His research has found that only about 4% of small businesses account for 70% of the total job growth usually attributed to small businesses.

Then there is the matter of wages and benefits. In 1991, the average monthly wage paid to employees in California companies with fewer than 100 workers was 22.5% lower than the average wages of those who worked for companies with more than 500 employees. Likewise, the smaller the firm, the more meager the employee benefit package (including health insurance) is apt to be.

Then too, small businesses comprise the most turbulent segment of the economy. Between 60 and 80 percent of small businesses fail within the first five years of operation. While responsible for creating large numbers of new jobs, small businesses also account for the vast majority of jobs destroyed. Unfortunately, too many casual observers mistake volatility for dynamism.

As the data suggest, government programs intended to aid 99.7% of all businesses probably need to be more discriminating. There is little reason to single out the smallest of businesses for special treatment when it is the really the more medium-sized and larger businesses which still seem to be the principal engines of job creation in California.

The Obsession with Manufacturing. Conventional economic wisdom ascribes enormous economic and social importance to manufacturing jobs. Yet most of what we think we know about manufacturing employment is at least a generation out-of-date. For example, the standard formulation that each manufacturing job supports three or four additional jobs has been kicking around for years despite monumental changes in the nation's manufacturing industries. Similarly, the U.S. Commerce Department's long-standing claim -- currently featured in the debate over the proposed North American Free Trade Agreement -- that each billion dollar increase in manufactured exports yields 50,000 new jobs is derived from an econometric model that was devised back when Jimmy Carter was president. That was well before import penetration and the transfer of American manufacturing jobs to overseas locations emerged as major issues. By contrast, recently revamped models suggest that the actual figure today is closer to 20,000 jobs.

The simple truth is that manufacturing jobs aren't what they used to be, either for the individuals who hold them or for the society as a whole. While manufacturing's share of U.S. economic activity has remained fairly constant over the past two decades, accounting for a steady 22%-23% of GNP, the proportion of the working population holding manufacturing jobs has declined steadily. In California, manufacturing's share of the workforce has dropped from 21.8% in 1973 to 17.1% in 1988, the year in which manufacturing employment reached its historical high in the Golden State. By early this year, only 15.2% of California's workers were employed in manufacturing.

The positive ripple effects associated with manufacturing are also becoming less evident. In the days of a far more insular, self-contained economy, U.S. manufacturers did have a pervasive impact on the regions in which they were located. Not only were they sources of relatively high- paying jobs, they were major customers for neighboring businesses. Today, however, with the emphasis on productivity, workforces are being slashed and wage and benefit packages held down. And instead of buying components and other supplies locally, companies now often obtain parts and supplies from far-away sources. (Nearly half of all imports into the U.S. involve shipments between divisions of the same companies.) The same is true with respect to the more high value-added services (e.g., design work, accounting services, software programming) required by modern industry. As a result, there are fewer positive benefits felt locally or even domestically today than a generation ago.

Equally salient is fact that a job "down at the plant" no longer supports the middle-class lifestyle enjoyed by workers in the 1950s and 1960s. Real average weekly earnings among production workers in manufacturing plants in California actually peaked about a generation ago. Even before the onset of the current recession, the average factory wage had declined in real terms by some 15.5% from 1972. During the same period, however, real per capita income in California rose by 16.8%, indicating the diminishing relative value of an average factory job.

The shifting composition of the state's (and the nation's) workforce as manufacturers employ a smaller and smaller percentage of American workers ought to be of greater concern to policymakers. The problem is very simple: a society is able to increase its living standards only to the extent its economy becomes more productive. All other things being equal, if we produce more than we did last year with the same resources we can afford to pay ourselves a little more and live a little better. Unfortunately, productivity gains have not been a notable feature of those industries in which most Californians now work. Yet without steady improvements in productivity, real wages (and hence living standards) for the great majority of Californians will remain stagnant, with predictable social and political consequences. Rather than striving to preserve manufacturing jobs at almost any cost, state officials might wish to give much more consideration to encouraging higher levels of productivity throughout the economy.

Only a few years ago, Californians seemed confident about meeting the intense competition posed by Japanese and German industry. As was manifested in corporate support for a gasoline tax increase and in reports such as the California Economic Development Corporation's "Vision: California 2010," the state's business leaders were fully capable of taking a thoughtful, long-term view of the state's economic development needs. In many respects, they seemed more committed than the state's political leaders to doing what was necessary to insure a bright economic future for California. Today the dominant concern appears to be whether California can compete against the likes of Utah, New Mexico and Arizona.

Those who hope that economic recovery will dramatically alter the legislative agenda of business groups are apt to be disappointed. In an age of global trade (and especially with a free trade pact with Mexico on the horizon), there will always be places where California companies can get the work done more cheaply than they can here. The question is where this state's leaders wish to draw the line at emulating our low-cost competitors.

Given prevailing attitudes toward taxes, much will depend on our capacity for adapting existing institutions rather than on looking for new money. If, for example, funds cannot be found for a serious and comprehensive program job training, then maybe it's time to transform the community college system into an apprenticeship cum retraining network serving local business needs. Although their rhetoric acknowledges that business-as-usual will no longer suffice, one is not altogether encouraged by political leaders who have somehow managed to convince themselves that one of the wealthiest societies in the history of the world cannot keep its public libraries open.

The good news is that economies do sometimes recover before the politicians figure out what to do. Given the current state of affairs at the Capitol, we should be so lucky.

Copyright (c) 1993 By J. A. O'Connell

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