How Did California Get in this Budget Mess?

June 30, 2003
DAVE DOWNEY, Staff Writer

As lawmakers continue to squabble over the state budget hours before the new fiscal year arrives, it is hard to comprehend how Sacramento got into this mess in the first place.  

For many, it is a mystery that California government could go from having a $12 billion surplus a few years back to forecasting a deficit three times that for fiscal year 2003-04, which begins at the stroke of midnight Monday.

State officials largely blame the problem on the 2001 recession and the dot-com bust, and certainly the economy has something to do with it. But the root causes of the biggest budget hole in state history go far deeper than that.

And, incidentally, the problem has nothing to do with the electricity crisis. While it is true that those blackouts rolled across the Golden State about the same time dot-com stocks were plunging ---- and that the state's general fund was tapped for billions to keep the lights on ---- every penny that was borrowed is being paid back by utility customers.

No, the problem was caused in part by the economic downturn and associated softening of state revenues. But it was compounded by officials' refusal to acknowledge that the enormous growth of the late 1990s was over and by the reluctance of policymakers to restructure spending accordingly, a regional economic expert says.

Christopher Thornberg, senior economist for the widely quoted UCLA Anderson Forecast, said state government has continued to spend and hire as if the boom was never going to end, while the private sector has downsized.

According to the state controller's office, 230,369 workers were on the payroll at the end of 2002 ---- 22,359 more than the 208,010 at the conclusion of 1998. That's 11 percent growth in the state bureaucracy in four years. Also in four years, total general fund spending has increased by 38 percent ---- even with emergency midyear cuts.

State of denial

"They (state officials) handled the budget crisis kind of like the power crisis: Please go away," Thornberg said at a recent Pasadena conference for journalists, covering his eyes with his hands and tilting his head down.

"They ignored the problem. They ignored the problem. And the problem continued to get worse," he said. "The problem has become so much worse because of a year and a half of complete inaction."

Legislative Analyst Elizabeth Hill, in a May 19 report that came days after Gov. Gray Davis unveiled his revised 2003-04 budget, noted that expenditures stayed about the same in 2001-02 though total revenues fell sharply from the year before. Hill also noted that general fund spending increased slightly this year to $78 billion, despite the fact that revenues, while improving, remained billions below that level.

If the state manages to adopt ---- and just as importantly, stick to ---- a balanced budget for 2003-04, it will be the first time in three years Sacramento has spent what it takes in.

The state has managed to maintain the general fund status quo by borrowing and raking surplus money off the top of other special funds. The general fund is what pays for most basic services such as K-12 education, universities, the Medi-Cal health-care program for the poor and state prisons that house 160,000 inmates.

The governor's spending plan for 2003-04 relies on still more borrowing and one-time deferrals of funding for programs, Hill said. It lacks the substantial restructuring of programs that is going to be necessary if expenditures are going to match revenues over the long haul.

Even with projected annual revenue growth of 6 percent starting in 2004-05, that healthy rate will be more than offset by spending increases, Hill predicted. That so-called "structural deficit" of $7 billion to $8 billion is expected to persist for years.

Spending on autopilot

The problem is many parts of the budget are on autopilot. The state expanded programs during the boom days. And, under existing laws, spending on them increases automatically year to year as enrollment swells and the cost of living rises. The governor and lawmakers, to date, have refrained from permanently downsizing programs or substantially trimming staff.

In short, while families and businesses cut back in response to the soft economy, the state balks at living within its means. And there is no sign Sacramento is going to start doing so anytime soon.

"The problem is not cyclical revenues, but cyclical expenditures," Thornberg said. "If we're going to cure this problem, we're going to have to have fundamental changes that cure cyclical spending."

One of those changes could be creation of a fat rainy-day reserve to cushion the state against the next economic slowdown, he said, to remove the political incentive "to spend every penny we get." There also is talk in Sacramento of an aggressive spending limit to cap growth in budgets so they keep pace with population growth and inflation, instead of growing much faster.

To hear Sacramento, the budget problem is disappointing revenues. Yet the state is expecting to take in $70 billion over the next 12 months.

"Revenues are not that bad," Thornberg said. "That's about where we were even as recently as 1999."

Much of the problem is this: Because of the budget autopilot and the governor's desire to expand additional programs, Davis was hoping to spend $90 billion next year. That underlying assumption is the basis for Davis' assertion that the state faces a $38 billion deficit, and why it is largely an imaginary shortfall. (The shortfall does, however, include the very real $11 billion in debt the state has run up the last two years.)

That $90 billion figure is rarely mentioned publicly in the context of the fiscal crisis. It represents a 16 percent, $13 billion one-year increase on paper over the $77 billion budget Davis signed into law for fiscal 2002-03, which ends Monday.

The state anticipates closing out this fiscal year having actually spent $78 billion.

The plunge

To be sure, revenues did take a fall.

The governor's budget summary reports that revenues reached a high of $75.7 billion in 2000-01, largely on the strength of soaring stock market income, then plunged to $62.7 billion the following year.

However, since then revenues have been growing, if not as fast as state officials would like. And the economy is not in terrible shape, Thornberg said.

It's just that investors overestimated profits to be made from the dot-com rush and over-invested. And he said it's taking time for the information industry and the overall economy to adjust.

"We are still suffering from the Internet rush hangover," he said.

Lasting three quarters ---- or nine months ---- in 2001, the last recession was one of the more moderate of 10 major economic contractions to hit the United States since the close of World War II. Unemployment grew 1.9 percent and gross domestic product shrank 0.6 percent. Both figures are well below average for recessions, Thornberg said.

The 2001 slowdown was followed by 2.4 percent growth in the gross domestic product in 2002, after adjusting for inflation. After contracting to balance itself following the unsustainable growth of the late 1990s, he said, the economy is moving toward the standard historic growth rate of 3 percent to 3.5 percent.

"We're a little bit off the mark, but not as much off the mark as you might think," Thornberg said.

Slow recovery foretold

There are several promising signs for the state and its government, the economist said.

For example, the information technology industry is growing again, which is good news for the battered San Francisco Bay area. Domestic corporate profits are improving. And labor productivity is growing rapidly.

Still, this particular slowdown is different than most, Thornberg said.

Typical cycles are marked by a steady but gradual expansion, a gradual contraction, then a sharp rebound to recovery.

In this most recent cycle, the economy was humming along at a steady clip, then accelerated to warp speed through the dot-com boom before the bust. Now we're seeing a gradual return to normalcy, Thornberg said. Almost nobody predicts a sharp rebound.

What it all means for the state is that officials can't rely on a roaring recovery to restore Sacramento's fortunes. Officials still face the hard decisions about restructuring programs that they have put off.

The bottom line is most recent budgets were built on unrealistic long-term revenue forecasts, Thornberg said, and the bounty of the late 1990s is not coming back.

Through the bust, he said, "the economy was going back to where it should have been in the first place."

Contact staff writer Dave Downey at (760) 740-3529 or ddowney@nctimes.com.

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